Asset Allocation
Highlights The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. Although it has been well over a year since the last 10% pullback, the U.S. equity market is not "due" for a correction. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction. What is Dr. Copper's diagnosis? We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a correction. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. We disagree. Feature U.S. stock prices remain within striking distance of their all-time highs and many investors continue to worry about the next correction. The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. The market has all but ignored the recent political turmoil in Washington. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction, while others note that it's been more than 15 months since the last 10%+ correction and that we are "due" for one. But is Dr. Copper still a reliable indicator of equity market tops? And if a correction is at hand, which assets would hold up best on the way down? We also review yet another disconnect between the Fed and the market: average hourly earnings. Geopolitical Risk Continues To Fade As A Market Concern Emmanuel Macron's victory was a resounding one as French voters rejected Le Pen's anti-Europe message in last week's election. Removing the possibility of a French President that is dedicated to exiting the eurozone is obviously positive for European stocks and investor risk appetite the world over. Next up are the two rounds of legislative elections in June. Polls are sparse, but they support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. A Macron presidency supported by Les Republicains in the National Assembly would be a bullish outcome for investors, according to our geopolitical strategists. On the international stage - where the president has few constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Republicains. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. The presidential election result in South Korea last week was exactly what the market expected, and should help to reduce tensions on the Korean peninsula. For now, the situation in Washington around President Trump's firing of FBI Director Comey has not had a major impact on markets. If the Democrats win the House of Representatives in 2018, our geopolitical team believes that impeachment proceedings will begin against Trump. On one hand, this means that polarization in the U.S. is about to reach record-high levels. On the other, it should motivate the GOP to get tax reform done before it is too late. Bottom Line: Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, but that is a risk for 2018. We expect market-friendly policies emerging from Washington this year, although the Comey affair highlights that the road will be anything but smooth. Corrections And Pullbacks In Context Geopolitical risk appear to have faded for now, but with U.S. equities at or close to all-time highs, talk of a correction is hard to avoid. We continue to favor stocks over bonds this year and suggest that any sell-off in equities will be bought not sold. A hard landing in China, major disappointment on the Trump legislative agenda, a prolonged spell of weakness in the U.S. economic data1, and an overly aggressive Fed in 2017 may all serve as catalysts for a pullback. Above average PE ratios and measures of market volatility that are at cycle lows have only added to the chorus of those saying we are "due" for a correction. History suggests otherwise. From the end of WWII through 2009, the S&P 500 has experienced, on average, two 10% corrections and 10 corrections of 5% of more during equity bull markets. Since the start of the current bull market in March 2009 we've had 22 pullbacks of 5% or more and six corrections of more than 10% (using market closing prices) Table 1. This suggests that the market has seen its fair share of pullbacks and corrections since 2009, and isn't really "due". Chart 1 takes a different approach, but reaches the same conclusion. At 15 months (325 days) since the end of the last 10% correction, the current bull market is right of the middle of the pack of all bull markets since 1932. Table 1Six S&P 500 Corrections Of 10% Or More Since March 2009: We're Not "Due" Chart 1Current Equity Bull Market Is Not Long In The Tooth Our view remains that any pullback in U.S. equities will be bought, not sold, and we favor stocks over bonds in 2017. There are few notable imbalances in the U.S. or global economies and we see an acceleration in both over the remainder of 2017. The Fed will raise rates gradually this year, and there is general agreement between the Fed and the market on the pace of hikes at least for 2017. The Fed and the market remain far apart on hikes in 2018. Our view of the economy and labor market suggests that the market will ultimately move toward the Fed's view. The U.S. corporate earnings outlook remains solid, after a very good Q1 earnings season and favorable guidance for Q2 2017 and beyond. Bottom Line: Equity pullbacks - even during bull markets - are normal and healthy. We do not believe that the market is especially "overdue" for a pullback, but when the inevitable pullback or correction occurs, we expect that investors will take the opportunity to add to equity positions and not turn the pullback into a bear market. Dr. Copper? Chart 2Metals Prices Are Rolling Over...##BR##But Is It A Signal? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 20% on a year-ago basis, but has fallen by 8% since February (Chart 2). From their respective peaks earlier this year, zinc and copper are down about 10%, nickel has dropped by 22% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Some of our global leading economic indicators have edged lower this year, as we have discussed in recent Weekly Reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart 3). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over (annual growth is shown on a 12-month moving-average basis in Chart 4 because of the extreme volatility in the series). Both the PMI and housing starts are correlated with commodity prices. Chart 3China is The Main Story##BR##For Base Metals Demand Chart 4Direct Fiscal Spending And Infrastructure##BR##Have Picked Up Recently The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: Chart 5Dr. Copper Is Not Signaling##BR##A Slowdown in Global Growth There is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Moreover, both direct fiscal spending and infrastructure investment have picked up noticeably in recent months (Chart 4). Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. This all adds up to a fairly benign outlook for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. We intend to update our view on oil prices in the May 22, 2017 edition of this report. Bottom Line: From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Chart 5 highlights that the LMEX base metals index has a high positive correlation with the U.S. stock-to-bond total return ratio on a daily change basis. However, in terms of trends and turning points, base metals are far from a reliable indicator for the stock-to-bond ratio. Where To Hide In A Stock Market Correction Over the past several years, BCA's U.S. Investment Strategy service has periodically recommended that investors add a variety of investments as portfolio "insurance" to help guard against the possibility of a material correction in equities. More recently, we have highlighted two specific forms of insurance: our yield and protector portfolios. We last discussed the protector portfolio in the October 17, 2016 and November 7, 2016 Weekly Reports2, and in today's report we revisit the issue by comparing both portfolios to a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. Charts 6, 7, and 8 show a breakdown of the relative performance of S&P 500 defensives along with our yield and protector portfolios. Panels 2 and 3 of Charts 6, 7 and 8 present the rolling 1-year beta and alpha of each strategy vs. the S&P 500. Here, we present alpha as the difference between the actual year-over-year excess return of the portfolio (vs. short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is sometimes referred to as "Jensen's alpha". Chart 6A Modestly Low-Beta Option Chart 7A Lower Beta Than Defensives Chart 8A Negative Beta, And Positive Alpha There are several noteworthy observations from the charts: Based on the historical beta of the three portfolios vs. the S&P 500, defensive stocks are the most correlated with the overall equity market. Our protector portfolio has a negative correlation to the broad market, and our yield portfolio is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 2); with our protector portfolio composed entirely of non-equity assets. Table 2A Breakdown Of Three##BR##Portfolio Insurance Options After accounting for their lower beta, all three portfolios have tended to outperform the S&P in risk-adjusted terms since the onset of the global economic recovery. But this outperformance has been more significant for our yield and protector portfolios: the top panel of Charts 7 and 8 highlight that both portfolios have generated essentially the same return as equities have since the end of the recession (since the relative profile has been flat), despite exhibiting considerably less volatility than stocks. All three portfolios have experienced a relative decline vs. the S&P 500 since the election, but this has largely occurred due to passive rather than active underperformance. In other words, they have underperformed due to a failure to keep up with the S&P 500 rather than because of losses in absolute terms. There are two important conclusions from Charts 6, 7 and 8 for U.S. multi-asset investors. First, the lower beta of our yield and protector portfolios compared with S&P defensives means that the former represent a better insurance bet against a sell-off in the equity market than the latter. Second, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets over the past few years, which is likely to persist over the coming 6-12 months. But investors should also recognize that this preference could eventually be subject to a reversal if the long-term economic outlook significantly improves, an event that could be catalyzed either by organic economic developments or policy decisions by the Trump administration. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. But our analysis suggests that clients who anticipate the need for portfolio insurance over the coming year should favor our yield and protector portfolios over a defensive sector allocation within an equity portfolio, and we are likely to recommend an allocation to these portfolios for all clients were we to see any material progression towards the sell-off triggers that we identified earlier in the report. Bottom Line: Investors seeking some protection against a potential equity market sell-off should favor our yield and protector portfolios over defensive sector positioning. We do not currently recommend these portfolios for all clients, but we are likely to do so if our key sell-off trigger "red lines" are breached. What's Up With Wage Growth? On the surface, the April jobs report-released in early May seemed to send mixed signals to investors and the Fed about the health of the labor market3. Our view remains that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation, which will lead the Fed to raise rates twice more in 2017. But even though the economy is very close to full employment and the output gap has nearly closed, patience is required. Although it's a close call, the next hike is likely to come next month. Markets remain somewhat skeptical of this view, and have only priced in 39 bps of tightening by the end of the year, and have not yet fully priced in a June rate hike. The lack of wage growth (up just 2.5% year-over-year in April according to average hourly earnings (AHE)) remains a key source of the market's skepticism about the pace and timing of Fed rate hikes. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. Does the Fed see something the market does not? Or is it the other way around? Markets tend to focus on data that are timely. That requirement certainly fits the AHE. The monthly wage measure is the most timely data point on labor compensation. While timeliness is an important factor when assessing the health of the labor market, it is also critically important to watch what the Fed watches. Investors should note that the AHE data is only one of at least four measures of labor compensation the Fed mentions in its Semi Annual Monetary Report to Congress. Since Fed Chair Yellen took office in 2014, the Fed has specifically referenced (and charted together) three measures of labor compensation in the report: Average hourly earnings Employment Cost Index and Compensation per Hour in the nonfarm business sector, and Chart 9The Fed Tracks All Four Of##BR##These Compensation Measures The Atlanta Fed's Wage Tracker was mentioned in the June 2016 Monetary Policy Report, and the Fed added it to the chart of the other three metrics in the most recent report, released in February 2017. As Chart 9 shows, all have moved higher in recent years, although it is clear that AHE has lagged the others. Given the attention it receives in the financial news media on and just after "Employment Friday" each month, it may surprise investors to learn that neither AHE nor wages were directly mentioned in any of the FOMC statements since Yellen took charge. However, wage growth (or lack thereof) has been a topic of discussion at all but a few of the 13 post FOMC press conferences Yellen has held. When asked about wages, she is careful to note that the Fed watches a wide range of indicators of labor compensation, but has lamented the lack of progress on wages. In her most recent press conference, Yellen noted that "I would describe some measures of wage growth as having moved up some. Some measures haven't moved up, but there's some evidence that wage growth is gradually moving up, which is also suggestive of a strengthening labor market." Average hourly earnings are routinely mentioned in the FOMC minutes, but only alongside mentions of the other metrics noted above. On balance, average hourly earnings are viewed by the Fed - and therefore should be viewed by the market - as one of several indicators of the health of the labor market, but not the only indicator. Chart 10 shows that only a third of industries have seen an acceleration in wage increases over the past year, which supports the market's view that the economy is not growing quickly enough to push up wages and inflation. A recent report by the Kansas City Fed4 takes a different view. Using a bottom-up approach, the author points out that only a few industries (mostly in the goods producing sector of the economy) have accounted for much of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail trade, professional and business services and leisure and hospitality - all service sector industries - have been the laggards. The study done by the economists at the Kansas City Fed shows that although earnings growth has lagged in those more service-oriented industries since 2015, hours worked have seen faster growth than in the mainly goods producing sector (chart not shown). This suggests to the author - and we concur - that labor demand has been strong in the past few years in areas that have not seen much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience may be required. Chart 11 shows that it takes two to three years after a bottom in the output gap for a decisive turn higher in ECI or AHE. While this cycle has seen a more shallow recovery - especially in AHE - both have moved higher since the output gap bottomed out in 2009/2010. Chart 10Only 33% Of Industries Have Seen##BR##Wage Acceleration Over The Past 12 Months Chart 11Measures Of Labor Compensation Move##BR##Higher After Output Gap Bottoms Out Bottom Line: Investors are always wise to watch what the Fed watches. The evolution of wage growth will be critical to FOMC policymakers, because a clear acceleration will confirm that the economy is truly at full employment and, thus, at risk of overheating. We do not expect a surge in wages, but a steady upward trend will keep the Fed on a gradual tightening path. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Reports "Portfolio Insurance: What, How, When?", dated October 17, 2016 and "Policy, Polls, Probability", dated November 7, 2016, both available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed" dated May 8, 2017, available at usis.bcaresearch.com. 4 See "Wage Leaders and Laggards; Decomposing the Growth in Average Hourly Earnings" The Macro Bulletin, February 15, 2017; Federal Reserve Bank of Kansas City.
Highlights Portfolio Strategy Upgrade capital markets stocks to overweight and put them on the high-conviction list. Capital formation is poised to accelerate in the second half of the year. Our Indicators suggest that demand for media services will continue to improve. Stay overweight both the movies and entertainment and cable and satellite indexes. Recent Changes S&P Investment Banking & Brokerage - Upgrade to overweight and add to the high-conviction overweight list. S&P Consumer Finance - Remove from the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature The S&P 500 continues to churn near its highs. Following a robust earnings season, the onus is now on the economy to provide confidence that the corporate profit recovery will prove durable, thereby justifying thinning equity risk premia. While slumping commodity prices suggest that global end-demand has downshifted a notch, the former boost real purchasing power and provide a reflationary support for stocks, particularly since resource-dependent sectors do not have a market leadership role. In fact, financial conditions remain sufficiently accommodative to expect a growth reacceleration in the back half of the year. It is notable that the recent selloff in the Treasury market has been driven by the real component, while inflation expectations have moved sideways. As a result, there is little pressure on the Fed to normalize at a faster pace than currently discounted in the forward curve. Thus, we expect the window for additional equity price appreciation to remain open this summer, unless growth reaccelerates sufficiently to stir inflation fears. Nevertheless, selectivity will become even more critical. Cross asset correlations have collapsed. Diminishing global macro tail risks have reduced the dominance of the beta-oriented "risk on/risk off" trade as a source of return. Empirical evidence suggests that asset correlations and the broad equity market are inversely correlated. This message is corroborated by falling correlations between regional stock market returns. Receding equity index correlations have been associated with positive S&P 500 returns (middle panel, Chart 1). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (top panel, Chart 1). These relationships are intuitive. Diminished macro tail risks bring earnings fundamentals to the forefront as the key driver of returns, and reward differentiation and discrimination in sector/region/asset class selection. While an eerie calm has dominated markets of late, as our Asset Class Volatility Indicator has collapsed to a multi-decade low (bottom panel, Chart 1), a more bullish explanation is that all-time highs in equities are synonymous with all-time lows in the VIX. This can be viewed as a contrary warning sign, but history shows that the VIX can stay depressed for a prolonged period. Our Equity Market Internal Dynamics Indicator (EMIDI), first introduced in late-March, has tentatively troughed, suggesting that sub-surface dynamics are becoming more supportive of the broad market (Chart 2). The EMIDI, which comprises relative bank, relative transport, small/large and industrials/utilities share prices, has been coincident to the leading market indicator, especially since the GFC. Chart 1Tumbling Correlations = Rising Stock Returns Chart 2Sub-Surface Dynamics Have Turned The Corner In that light, this week we are further augmenting our cyclical portfolio exposure by lifting another interest rate-sensitive group to overweight and are also updating the early cyclical media index and its major components. Capital Markets Stocks Have Rally Potential Two weeks ago, we recommended using this year's financial sector underperformance to boost allocations to overweight. This week we are further augmenting our exposure by upgrading the S&P investment banks & brokerage index to above benchmark. While the equity bull market is in the later innings, our view is that the overshoot will be extended for a while longer as a consequence of the overall sales and profit recovery and low probability that monetary conditions will tighten meaningfully in the near run. If this plays out, there is an opportunity for capital markets stocks to recover from their recent consolidation. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew (Chart 3), reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex demand, not weak corporate cash flows. This is confirmed by BCA's Capital Spending Indicator, which signals an increase in business investment ahead. Consequently, corporate sector demand for external capital should accelerate. The latter is the lifeblood of capital markets profitability. The nascent recovery in total bank credit growth after a period of malaise reinforces that working capital requirements are on the upswing (Chart 3).1 As businesses shift from maintenance capital spending to a more expansionist mindset, and companies reach further for growth to justify high stock valuations, capital markets activity could accelerate in the second half of the year. After all, investor confidence is high. Corporate bond spreads have tightened and corporate bond issuance is soaring. The Equity Risk Premium is steadily narrowing (shown inverted, second panel, Chart 4), reducing the cost of equity capital. New stock issuance is following on the heels of corporate bond issuance. Stocks are outperforming bonds by a comfortable margin and total mutual fund assets have grown sharply (Chart 3). The upshot is that access to corporate sector capital should stay healthy. As flows into equities advance, it will fuel a reacceleration in M&A activity (Chart 5). Chart 3Capital Markets Activity Is... Chart 4...Firing On All Cylinders Chart 5ROE On The Upswing Capital markets return on equity (ROE) is highly levered to business and investor risk appetite. Fees earned on M&A activity heavily influence overall profitability. As such, it is normal for ROE to expand when M&A activity picks up, and shrink when financial conditions tighten and takeovers dry up. Currently, M&A transactions represent an historically elevated share of GDP, but that is not a barrier to an increased rate of takeover activity. Companies are no longer using their balance sheets to repurchase their own shares en masse. Instead, there is an incentive to pursue business combinations as the global economy reaccelerates, underscoring that capital allocation should shift in favor of capital markets firms. Indeed, Chart 5 shows that ROE also follows the trend in our global leading economic indicator, and the current message is bullish. Even capital markets companies themselves confirm that their pipelines are full. Hiring activity remains robust. Pro-cyclical firm headcount rises quickly alongside revenue opportunities, and is just as quick to shrink when the outlook darkens. Ergo, we interpret headcount growth as a net positive. While trading activity is always a wildcard, and could be a source of weakness if bond market, and generalized asset class, volatility stays muted, the upbeat outlook for fee generation from increased capital formation provides us with confidence to use share price weakness as an opportunity to build a bigger position. Bottom Line: Lift the S&P investment banking & brokerage index to overweight, adding to our recent decision to upgrade the overall financials sector to above-benchmark. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC. Media Stocks: Temporary Pressure Media stocks have come under pressure recently, giving back all of this year's relative gains. Investor worries have centered around two thorny issues: cord-cutting and ad spending. Cord-cutting is not new, but weak overall Q1 TV subscriber numbers have refocused investors' attention on the secular challenges ahead. In addition, a number of companies noted softening ad spending on Q1 conference calls. According to media executives, this slowdown is not isolated to the automotive segment. Is it time to pull the plug or is a worst case scenario already priced into the group? We side with the latter. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel, Chart 6). Despite coming off the boil recently after hitting unusually high growth rates, media pricing power also remains in expansionary territory. Importantly, buoyant demand is boosting industry productivity gains. The third panel of Chart 6 shows that our media productivity proxy has reaccelerated. Meanwhile, an improving economic backdrop also bodes well for media earnings prospects. The ISM services new orders sub component has been an excellent leading indicator of relative profit growth expectations and the current message is positive (middle panel, Chart 7). If the overall economy bounces smartly from the weak Q1 print, as we expect, then an earnings-led recovery should sustain the valuation re-rating phase (bottom panel, Chart 7). Chart 6Buoyant Media Demand Chart 7Valuation Re-Rating Looms Our Ad Spending Indictor (ASI) incorporates all of these key media profit drivers, including consumption and overall corporate profits. The ASI has recently hooked up, signaling that earnings estimates should continue to rise (bottom panel, Chart 8). Nevertheless, sub-media group returns have been bifurcated, with the S&P movies and entertainment index exerting downward pressure on the overall sector of late. Relative performance has mostly treaded water since our upgrade last summer, but hit a soft patch after recent quarterly results. Before rushing to make a bearish judgment, it is notable that the relative forward P/E remains close to an undervalued extreme, signaling that it will be increasingly difficult to disappoint. Historically cheap valuations exist despite depressed expectations, which should serve to artificially inflate valuations: both top and bottom line are expected to lag the broad market, representing a very low hurdle (Chart 9). Chart 8Rosier EPS Prospects Lie Ahead Chart 9Unloved And Undervalued Beyond the positive consumer spending backdrop (Chart 10), we are inclined to stick with overweight positions in this sub-component for four major reasons. First, merger and acquisition activity should reduce capacity, and by extension, support pricing power, especially if the AT&T/Time Warner deal clears the regulatory hurdle. There is scope for additional M&A that could further reduce shares outstanding (Chart 11). Chart 10Improving Demand... Chart 11...And M&A Activity Are An EPS Tonic Second, content providers are adapting to the competitive threat. New online-only offerings and slimmer/nimbler packages should stem the drag from the likes of Netflix and other streaming services. Consumer spending on electronics continues to surge, suggesting that content providers have ample opportunity to fill increasing demand. Third, there is no substitute for live TV. News and live sports are two sticky offerings that will continue to be cash cows for the industry and drive select subscriber growth. Fourth, media giants have stepped up focus on other segments with higher growth potential, such as studios and franchises highlighting increasingly diversified revenue streams. Moreover, CEOs have been aligning cost structures to the new realities of cord-cutting, exercising strict cost control. Companies have also been careful with capex allocation decisions. All of this suggests that any shakeout in this media subgroup is a good entry point for building new positions with a compelling valuation starting point. Unlike the S&P movies and entertainment index, the S&P cable and satellite group has been relentlessly grinding higher, underpinning the broad media index. The multiyear share price advance has been cash flow driven. As a consequence, cable stocks still trade at a 25% discount to the broad market on a price/cash flow basis and the relative multiple is hovering near the historical mean (third panel, Chart 12). Cable and satellite sales growth has surged to healthy low double-digit growth rates after a one year lull. Encouragingly, soaring pricing power signals that recent revenue momentum is sustainable (second panel, Chart 12). As mentioned above, consumer outlays on cable services have had a V-shaped recovery, underscoring that the latest upleg in selling prices is demand driven (bottom panel, Chart 12). It is remarkable that the industry has consistently raised selling prices at a faster pace than overall inflation for decades (Chart 13). This impressive track record reflects cable operators' ability to continually evolve offerings and provide attractive content, even in the face of cord-cutting. Chart 12Cash Flow Driven Outperformance Chart 13The Cable Signal Is As Strong As Ever Meanwhile, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins are limited (bottom panel, Chart 13). More recently, news that Comcast and Charter will come together and cooperate on a wireless offering adds another layer of defense in effectively combating cord-cutting. How? By increasing the bundle offering beyond cable and internet services, cable providers are positioned to attract new clients by offering a one stop shop triple-play solution. A move into wireless service offerings would also assist in retaining existing customers. In sum, most of our indicators suggest that the demand outlook for media services continues to improve. Our Ad Spending Indicator is climbing, underscoring that fears of a deep and widespread slump are overblown. Bottom Line: The media index remains an overweight and we continue to recommend an above benchmark exposure both in the S&P movies and entertainment and S&P cable and satellite sub-groups. The ticker symbols for the stocks in these two indexes are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. 1 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds," dated April 11, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The Economic Surprise Index has declined and may continue to roll over until expectations wash out. But that shouldn't derail risk assets or the Fed. The GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The FOMC called the weakness in Q1 "transitory". The U.S. economy can grow fast enough over the final three quarters of the year to meet the Fed's 2.0% growth target. The recent readings on inflation and the labor market remain consistent with 2 more rate hikes this year, starting in June. We expect the stock-to-bond ratio to hit new highs by the end of the year even without a big move in equity prices. Feature U.S. equities have now returned to their early March highs despite the ongoing weakness in economic surprises. The latest high profile negative surprises were in the Q1 GDP report, and the March reading on core PCE inflation. Have equity prices disconnected from the underlying economic fundamentals or is something else at play? More importantly, how does the Fed view the recent weakness in economic data? The outlook for inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. What To Expect After A Weak Q1 The Q1 GDP report was weak. It was the latest in a string of U.S. economic reports stretching back to mid-March that have disappointed relative to (raised) expectations. In February,1 we highlighted the risk that the "current period of economic surprise could last for another month or two..." before inevitably giving way to elevated expectations and finally disappointment. On average since 2010, elevated levels of economic surprise have lasted roughly two months, with the latest period lasted about 11 weeks (Chart 1). So now what? Chart 1Economic Surprise Index Has Rolled Over Since Early to Mid March Each day that passes, economic expectations move lower, adjusting the bar down for the next batch of economic reports. The starting point was set relatively high just after last fall's election and early this year, as investors anticipated quick action from the Trump Administration and Congress on tax cuts, tax reform and infrastructure. More recently however, some of the key data have not only failed to match raised expectations, but have begun to roll over. Since 2010, periods of disappointing economic reports have persisted, on average, for 4 months (Chart 1). We are nearly 2 months in, implying that expectations will be washed out soon. With a solid backdrop for corporate earnings, and ebbing geopolitical risk, any equity pullback based on near-term weakness in the economic data should be short-lived. Q1 real GDP growth came in at just 0.7%, well below expectations of a 1.1% increase. At the start of 2017, consensus estimates were in the 2 to 2.5% range, but we were not surprised by the weak report and markets should not have been either. In our two most recent reports,2 we highlighted the well-known seasonality issues with Q1 GDP. Markets seemed to have - correctly in our view - taken the Q1 GDP report in stride and are looking ahead to Q2 and beyond. We expect a snapback in growth in Q2 and over the rest of 2017. The Atlanta Fed's Q2 estimate (+4.2%) supports our view but the NY Fed's latest nowcast for Q2 (+1.8) suggests a more modest rebound. In addition to the potential for higher growth later in the year, there is also the chance that Q1 growth was misstated. Investors can track revisions to Q1 GDP via the Atlanta and NY Fed's Nowcasts, and should bear in mind that the GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The Bureau of Economic Analysis' (BEA) GDP data are subject to near constant revision. For example, the Q1 2007 GDP data (released in April 2007) has already been revised 10 times (Table 1). Availability to the BEA of input data that is both timely and comprehensive is at the root of this constant revision. Investors need to take this into account as they try to assess the health of the U.S. economy in "real time". In the past 8 years, Q1 GDP has been revised lower half the time between the advance estimate (1/3 of the hard data) and the second estimate (50% of the data). But as currently reported, Q1 GDP in 5 of the last 8 years is now higher than it was when first reported and in some cases these revisions have been significant in magnitude (Table 1). Which reading should investors trust? A look at the composition of those estimates may help. Table 1GDP Is A Mix Of Art And Science When the BEA released Q1 GDP in late April it had collected just over a third of the "hard" data that feeds into GDP (Chart 2). The rest of the data used to calculate Q1 GDP was filled in by the BEA using assumptions, or "judgmental trend," or by using data from a similar data series. By the time the second estimate is released in late May, the BEA will have just 50% of the "hard" data. Thus, a healthy dose of skepticism is warranted when evaluating the U.S. economy on the initial reports of GDP. Chart 2Advance Estimate Of GDP##br## Is More Art Than Science For now, U.S. equities have not been affected by the weak Q1 GDP data or the recent collapse in positive economic surprises. Our work shows that the disappointing economic data may persist for another few months. Stocks are within a few points of their all-time high set in March; which suggests that markets are less focused on the noise in the economic data, but remain intently focused on the Trump Administration passing some profit friendly legislation at some point this year. If economic disappointments persist for longer than a few more months and Congress doesn't follow through, we can't rule out a meaningful correction in U.S. equities. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. Bottom Line: Investors should fade the recent disappearance in positive economic surprises by staying overweight stocks vs bonds over the coming 6-12 months. FOMC: Growth Weakness Is Transitory Chart 3GDP, Inflation And Labor Market All Tracking##br## To Fed's Forecast = Gradual Rate Hikes The pace of economic growth, and more importantly how that growth impacts the labor market and inflation, remain a crucial factor in how investors assess the number of additional Fed rate hikes that can be expected this year. We continue to expect two more 25 basis point hikes in 2017, whereas the market, as of May 4, was pricing in just 38 bps. At the start of the weakness in the economic data in early March, the market had penciled in 68 bps (almost 3 rate hikes). The soft performance of the economy in Q1 was certainly a focus at last week's FOMC meeting. The FOMC's assessment was that the slowdown in growth in the economy in Q1 was "transitory." The FOMC made no material changes to its assessment of inflation or the labor market in the statement. The minutes of last week's meeting due on May 24 will provide more color. While not officially part of the Fed's dual mandate (of inflation and unemployment), economic growth obviously matters to the Fed. Growth that runs above the Fed's view of potential GDP will push the unemployment rate lower and push inflation higher. Top panel of Chart 3 shows that real GDP growth rose 1.9% from a year ago in Q1, just a tenth of a percent below the Fed's central tendency range for 2017 of 2.0 to 2.2% (Chart 3, panel 2). Despite the poor start to 2017, real GDP growth would have to average only a modest 2.5% per quarter over the rest of the year to hit the Fed's 2.0% target. Is 2.5% growth over the final three quarters achievable absent positive revisions to Q1? We think it is. Since 2010, GDP growth in the final 3 quarters of the year has averaged 2.5%. The headwinds facing the economy today are weaker than they were in the early years of the recovery. The April readings on manufacturing (54.8) and non-manufacturing (57.5) ISM imply GDP growth in the 3 to 3.5% range in Q2. The FOMC is correct to look through the temporary weakness in Q1 and continue on its gradual path of rate hikes this year to match the "modest" pace of economic growth. Investors got a few other key inputs to the FOMC's decision making process last week: The March reading on PCE inflation and the April employment report. Both readings keep the Fed on track for gradual hikes in 2017. A soft reading on core PCE inflation - the Fed's preferred measure - was also a contributor to the weakness in the economic surprise index. For now, we see few signs that suggest core inflation is headed sustainably lower. Chart 4 shows that, since 2000, core PCE inflation has closely correlated with a one year lag of real consumer spending. Even with the recent deceleration in spending, the chart suggests that the recent decline in inflation is temporary. In addition, our sense is that the Fed is more likely to tolerate a rate of inflation that is modestly below its estimate as long as growth remains strong and there is evidence that the weakness in inflation is transitory. Chart 4Core PCE Inflation Likely To Move Higher To Meet Spending The April labor market data was released last week as well and confirmed the FOMC's assessment of a solid labor market, but it also had a one negative surprise for markets. The 211,000 increase in jobs in April exceeded expectations (+185,000) and accelerated from the 79,000 gain in March. Over the past three months, the average monthly gain in payrolls was 174,000,well above the 100,000 to 125,000 per month pace the Fed says is needed to tighten the labor market. The drop in the unemployment rate in April to 4.4% puts the unemployment rate at pre-recession lows and more importantly, below the lower end of the Fed's 4.5% to 4.6% central tendency for this year. (Chart 3, panel 3). The negative surprise in the April jobs report came from wages. Average hourly earnings decelerated to 2.5% year-over-year in April from +2.6% in March. The consensus was looking for a 2.7% increase. Despite the lack of traction on wages, the April jobs supports the view that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation. June remains a close call for the next Fed rate hike, but an analysis of the economy and the Fed's reaction function suggests that two rate hikes remain the most likely event this year. Our view is that the market will adjust up expectations toward the Fed's view for 2018. Bottom Line: The recent disappointment in the data is not enough to knock the Fed off course. Investors should continue to expect two additional rate hikes in 2017, with the next move coming at the June meeting. A Pro-Cyclical Asset Stance: It's Not Just About Stocks Chart 5Investors' Preference For Bonds##br## Is Understandable... One of the most basic ways that BCA evaluates the trend in financial markets is to look at what we call the "stock-to-bond ratio". In this publication the ratio is shown as the S&P 500 total return index divided by that of U.S. 10-year government bond. Chart 5 shows the amazing evolution of the stock-to-bond ratio over the past decade, rebased to 100 at the end of 2007 (the official beginning of the 2008-2009 recession). Panel 2 of the chart shows the component total return indexes, also rebased to 100 at the end of 2007. The chart illustrates two incredible points. First, while it is true that stocks have massively outpaced bonds since the low in March 2009, it took equity investors who bought and held at the onset of recession until late-2013 to outpace bond investors who did the same. Second, until the U.S. election in November, the stock-to-bond ratio was only 10% higher than it was in December 2007, which is a powerful testament to the ability of bonds to preserve capital over the long haul. Given these observations and the still-fresh memory of the global financial crisis, it is easy to see how some investors continue to prefer the relative safety of bonds, especially since equity multiples have risen significantly over the past year. However, Chart 6 highlights how our long stock-to-bond call is motivated by an expectation of higher stock prices and negative returns from bonds. The chart shows the likely trajectory of the 10-year Treasury yield over the coming year, under the base case scenario envisioned by our U.S. Bond Strategy service: core PCE inflation rises to 2%, and the spread between the 10-year breakeven inflation rate and core rises to 50 bps. Chart 7 illustrates the implications of this forecast for bond total returns, alongside the resulting stock-to-bond ratio. For stocks, we assume a very conservative 3% annualized nominal total return, which is the sum of a 2% dividend yield and a 1% assumed nominal price return. Chart 6...But The Bond Bull Market Is Over Chart 7A New High By Year-End The key point from Chart 7 is that the stock-to-bond ratio is likely to rise to a new high by the end of the year, even without aggressive assumptions for equity returns. We agree that bond yields will fall in the event of another risk-off event, and that 10-year Treasurys remain an important component of a diversified portfolio. But it is also important for investors to recognize that, absent these types of events, the relative performance of stocks vs. bonds is set to move higher in part because 10-year Treasurys are likely to generate a negative absolute return over the coming 6-12 months. Bottom Line: Investors should retain a pro-cyclical asset allocation stance. The outlook for the inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "Goldilocks: For How Long?," dated February 20, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Reports "Spring Snapback" dated April 24, 2017 and "The Good And The Bad". May 1, 2017, available at usis.bcaresearch.com.
Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Chart 6Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights We are going long spot gold at tonight's closing price, given our view that inflation and inflation expectations will continue to move higher going into 2018. In the U.S., we expect higher fiscal spending and tax cuts hitting the economy next year to have a significant effect on an economy already at or very close to full employment, boosting real wages and inflationary pressures. As a safe-haven, gold also is well suited to hedging geopolitical risks, which also are rising. Lastly, gold exposure has the added benefit of providing a hedge to equity positions. Energy: Overweight. The ~ 10% correction in benchmark crude oil prices from 1Q17 levels likely has run its course, as representatives of key states that are party to the November 2016 production cut deal signal it will be extended at the upcoming May 25 meeting in Vienna. We remain long Dec/17 Brent $65/bbl calls vs. short the Dec/17 Brent $45/bbl puts, which is down $0.88/bbl, and will be getting long Dec/17 Brent $55/bbl calls vs. Dec/17 $60/bbl calls at tonight's close. We expect Dec/17 Brent to reach $60/bbl by year-end, with WTI trading ~ $2.00/bbl lower. Base Metals: Neutral. Indonesia's state mining company PT Aneka Tambang is expected to resume nickel exports, reversing a three-year ban on outgoing trade. We remain neutral base metals. Precious Metals: Neutral. We are recommending an allocation to gold outright as a strategic hedge against higher inflation, particularly emanating from the U.S., and geopolitical risk in Europe (see below). Underweight. Markets remain well stocked with indications stocks-to-use data will continue to weigh on prices. We remain bearish. Feature Recent indications inflation and inflation expectations are ticking higher will persist into 2018 (Chart of the Week). U.S. fiscal spending and tax cuts expected next year will lift real wages and boost spending power. The American economy already is at or very close to full employment, and U.S. rate hikes are lagging wage growth, which will, all else equal, boost inflation and inflation expectations (Chart 2). Although we expect the Fed to raise rates at least two more times this year - perhaps three - we believe the central bank will continue to keep rate hikes behind wage growth, and will not try to get out in front of inflation (Chart 3). Chart Of The WeekGlobal CPI Inflation Continues To Percolate Chart 2Rate Hikes Lagging Wage Growth Chart 3Fed Likely Won't Get Ahead Of Inflation On the political and geopolitical fronts, looming Italian elections are a risk that is all but being ignored by financial markets. Our colleague Marko Papic, head of BCA's Geopolitical Strategy service, identifies next February's Italian elections as "the highest probability risk to European integration at the moment," given its potential to "reignite Euro Area breakup risk."1 Political risks dog the DM economies: falling support for globalization, which will undermine the benefits of sourcing low-cost inputs (labor and capital) worldwide; tighter immigration policies, which go hand-in-hand with falling support for globalization; a predisposition to monetize debt via higher money supply; and higher minimum-wage demands as income inequality increases all raise inflation and inflation expectations in DM economies.2 This financial and political backdrop again points us toward gold in an attempt to identify safe-haven assets and hedges against the increasing likelihood of renewed inflation. In addition, while our House view does not include a marked equities correction in the near term, it is worthwhile pointing out that gold does hedge equities when they are selling off, and in bear markets generally. A corollary to this property is that in equity bull markets, gold tends to hold value, even if it underperforms stocks in absolute terms. These are powerful properties, which increase the stability of investors' portfolios. Before proceeding, it is useful to distinguish between the specifications mentioned above:3 A safe-haven asset refers to an asset that is negatively correlated (or uncorrelated) with other assets that lose value in times of financial stress. An important feature of a safe-haven asset is that it only exhibit low or negative correlation with financial assets (e.g., equities) in extremely negative market conditions, without specifying any particular behavior when markets are not under stress. In other words, both assets could be positively correlated in bull markets, as long as the correlation turns negative when financial-market conditions deteriorate. We make a distinction between the weak and strong form of safe-havens: The weak form represents an asset that is uncorrelated with the reference asset, while the strong form is negatively correlated.4 A hedge is an asset that is negatively correlated (or uncorrelated) with another asset, on average, over the time interval being examined in a particular analysis. As with safe-haven assets, there is a similar distinction between weak- and strong-form hedges. A diversifier refers to an asset that is positively, but imperfectly, correlated with another asset on average during the period of analysis. Gold Vs. Inflation During inflationary periods, assets that generate returns for investors that offset purchasing-power losses experienced by other assets in their portfolio - i.e., a store of value - traditionally have been preferred. Gold has been used as a store of value during inflationary episodes, and for this reason is viewed as a safe haven. Fundamentally, gold's supply is relatively inelastic, and consists of above-ground physical stocks comprising public and private holdings. The world gold council estimates physical gold stocks were ~ 4570.8t at the end of 2016, up 5.8% since 2010. Demand for gold was estimated at 4249.1t at the end of 2016, versus 3281t at the end of 2000. The inelasticity of gold supply makes it difficult to respond to changes in inflation - or to any shocks to the economy, for that matter - by increasing the supply over the short term, as it would be the case with any fiat currencies and other assets. For this reason, price allocates limited supply. During inflationary periods and during a macroeconomic shock, gold's price is bid up, which is the source of returns for holding gold.5 Gold often is seen as a currency; however, it lacks a central bank that can increase its supply via turning up the printing press. This makes the precious metal a so-called "hard currency," and endows it with the ability to maintain its purchasing power during periods of inflation. In addition, it is an asset that is accepted as collateral to support bank lending and margining by the BIS and numerous banks.6 In Table 1, we look at the correlation between year-on-year gold return and U.S. CPI inflation.7 We used a sample period from 1985 to now.8 On average, during the entire sample, we obtained a correlation of 26%. Within the sub-periods gold provides a hedge against inflation, but how much of a hedge depends on other financial factors - chiefly the broad USD TWI and real U.S. interest rates - affecting its performance (Chart 4). We examine these below. Table 1Gold Vs. U.S.##BR##And EU Inflation Chart 4Gold's Inflation-Hedging Properties##BR##Affected By Monetary Conditions The hedging relationship between gold returns and the CPI inflation rates does not consistently hold up in all bear markets - e.g., the GFC, when global assets became highly correlated and lost significant value. It is possible, though, that in times of financial stress or downturn, gold's ability to act as a hedge asset to U.S. equities might sometime dominates its ability to hedge inflation, leading to an ambiguous relationship with inflation during bear markets. We delve further into this below. Gold, Inflation And U.S. Monetary Conditions We typically model gold as a function of financial variables, which are sensitive to inflation and inflation expectations and to Fed policy shifts. Given our preference for modeling gold's price evolution as a function of U.S. financial variables - the broad trade-weighted (TWI) USD and real rates, in particular - we looked further into this (Chart 5). The impact of inflation on gold prices is stronger when the dollar experiences large negative shocks and depreciates, and weaker when the USD appreciates (i.e., a large positive shock).9 So, when the USD broad TWI is falling, gold is an effective hedge. When the greenback is appreciating, it is less effective. Next, we examined the ability of gold to hedge inflation risk when U.S. real rates are high and low. To do this, we used 10-year real rates and cut a long-term sample from 1990 to now into two different sub-periods: a high-rate period from 1990 to 2003, and a low-rate period from 2003 to now (Chart 6).10 Chart 5USD's Evolution Is Important To Gold,##BR##As Are U.S. Real Rates Chart 6U.S. 10-Year##BR##Real Rates During the high-real-rate period, the correlation between gold and inflation is close to zero (0), meaning gold did not act as a strong hedge against inflation, but still could have been acting as a weak hedge (meaning it's uncorrelated). Gold's hedging ability increased significantly in the low-real-rate period (Table 2). Again, this supports our theory that gold's hedging ability depends on U.S. monetary conditions, and that during periods of low real U.S. interest rates gold is an effective hedge against inflation. Table 2Gold Vs. CPI Inflation In High- And Low-Real Rate Environments Gold Vs. U.S. Equities Cutting right to the chase, gold can be used to hedge equities exposure in portfolios, as the correlation analysis in Table 3 demonstrates. Here, we are examining the hedging ability of gold relative to the U.S. stock market (proxied by the S&P 500 Total Return (TR) index). Table 3Gold's Hedging Properties Vs. Equities In our analysis, we find gold and U.S. equities are negatively correlated, on average, over the entire sample (correlation coefficient -0.19). We also tested for time-varying correlation by looking at the correlation separately in different bull- and bear-market sub-periods. Bull (bear) markets are defined as periods in which the U.S. stock index has a positive (negative) move of more than 15% and that lasts for at least 3 months.11 During both bear markets, gold's annualized compound returns were up when the S&P 500 returns were negative (Table 4). This strongly suggests gold is a safe-haven asset in time of extended weakness for equities, all else equal (i.e., we don't have a 100-year global meltdown that takes all correlations to 1.00). Interestingly, the relationship is unclear for bull markets which reflects the non-linearity in gold's hedging ability. We can conclude that during bull markets, gold tends to underperform equity markets; however, this does not imply that holding gold will lead to negative returns. Hence, gold offers protection against bear markets that offsets the costs in terms of returns during bull markets.12 Table 4Gold Hedges U.S. Equities The correlation between month-on-month gold and S&P 500TR returns corroborate the earlier finding. We find that gold is negatively correlated with U.S. equities during equity bear markets, and that it is ambiguous in equity bull markets. Bottom Line: We find gold is a good hedge during inflationary periods, particularly when the USD TWI is weak and real rates are low. We also show gold has excellent safe-haven and hedging properties versus equities (using the S&P 500TR index as a proxy). Based on this analysis, we are recommending a strategic allocation to gold, and will get long at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Please see "Political Risks Are Understated in 2018," published on April 12, 2017, by BCA Research's Geopolitical Strategy. It is available at gps.bcaresearch.com. 2 Please see "The End Of the Anglo-Saxon Economy?" published April 13, 2016, by BCA Research's Geopolitical Strategy. It is available at gps.bcresearch.com. 3 Baur, Dirk G.; Brian M. Lucey (2010), "Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold". The Financial Review 45, 217-229. 4 Baur, Dirk G.; Thomas K.J. McDermott (2010), "Is Gold a Safe Haven? International Evidence", Journal of Banking & Finance 34, 1886-1898. 5 We would note that the real price of gold increased during the Great Depression, which indicated gold's value during a period of significant deflation appears to increase, perhaps as investors fear the debasement of their currencies and the subsequent loss of purchasing power. 6 Please see Section 4 of "Basel III counterparty credit risk and exposures to central counterparties - Frequently asked questions," published by the BIS December 2012. 7 We use CPI here because it drives the payout of inflation-linked securities in the U.S. 8 We begin our analysis in 1990 for consistency throughout. We also note that several papers take note of an important structural break in U.S. inflation around 1984. Please see Batten, Jonathan A.; Cetin Ciner; Brian M. Lucey (2014), "On The Economic Determinants Of The Gold-Inflation Relation", Resources Policy 41, 101-108; and Stock, James H.; Mark W. Watson (2007), "Why Has U.S. Inflation Become Harder to Forecast?", Journal of Money, Credit and Banking 39 (supplement). For the selection of bear and bull markets, please see "Monthly Economic Report" published on April 2017, by Mackenzie investments. 9 We did this by estimating a regression to see how gold responds when the broad trade-weighted USD is trading in the 5% and 90% quantile of year-on-year U.S. dollar variation over the period 1995 to present. We did this using dummy variables to represent the impact of U.S. inflation in periods of large dollar appreciation and dollar depreciation. The model's adj-R2 is 0.45, and all coefficients are significant below 5%. 10 The mean for the high-rates period is 3.77%; for the low-rates period it is 1.07%. These rates are statistically different between these two sub-periods (using a two-tailed t-test). 11 The selection of bull and bear markets is based on Mackenzie investment analysis. Please see "Monthly Economic Report" published on April 2017, by Mackenzie investments. 12 Our results were supported by further econometric analysis of the variance properties using GARCH modeling. These results are available upon request. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary Of Trades Closed In 2016
Highlights The global credit impulse is 4 months into a mini-downswing, and it is too soon to position for the next mini-upswing. The euro area economy will remain one of the better performers in a global growth pause. Underweight German bunds in a global bond portfolio. Stay long the euro, especially euro/yuan. Go long euro area Financials versus U.S. Financials, currency unhedged, as a first foray into a beaten-up sector. Feature First the good news: the ECB's latest bank lending data indicate that the euro area 6-month bank credit impulse is stabilizing after a modest but clear decline in recent months (Chart I-2). Now the bad news: the global bank credit impulse continues to weaken. The upshot is that the euro area economy - even with 1.5% growth - will remain one of the better performers in what is now a very clear global growth pause. Chart of the WeekThe Global Bond Yield Has Shown ##br##A Regular Wave Like Pattern Chart I-2The 6-Month Credit Impulse Has Stabilized In The ##br##Euro Area... But Not In The U.S. Or China How To Play The Euro Area's Economic Outperformance In a global growth pause, the best way to play euro area economic outperformance is through relative positions in the bond markets and through currencies. Specifically, underweight German bunds in a global bond portfolio but stay long the euro, especially euro/yuan. The implication for euro area equities is more ambiguous. The Eurostoxx50 has a very low exposure to Technology, which tends to perform defensively in a growth pause. Conversely, the Eurostoxx50 has a high exposure to Financials, whose relative performance reduces to a play on the bond yield (Chart I-3). Given that the global credit impulse is still weakening, it is premature to expect a sustained absolute rally in Financials anywhere. Therefore, the strong knee-jerk absolute rally in European banks after the French election first round is unlikely to last. That said, with the euro area economy likely to outperform in a global growth pause, and euro area Financials still near a 50-year relative low versus U.S. Financials, euro area bank equities can now outperform banks in other markets (Chart I-4). Chart I-3Global Bond Yield = ##br##Financials Vs. Market Chart I-4T-Bond/German Bond Spread Compression =##br## Euro Area Financials Outperform U.S. Financials As a first foray into a beaten-up sector, go long euro area Financials versus U.S. Financials, currency unhedged. (Caveat: all of this assumes that Emanuel Macron beats Marine Le Pen to the French Presidency on Sunday, as we expect.) Don't Rely On Year On Year Comparisons Nature provides many of our units of time. The earth's orbit around the sun gives us a year; the moon's orbit around the earth gives us a month; the earth's rotation on its axis gives us a day. But there is absolutely no reason why economic and financial cycles should follow nature's cycles. Yet most analysts persist at looking for patterns and cycles in economic and financial data using yearly, monthly, or daily rates of change. Unfortunately, by focusing on years, months and days, they risk completely missing some of the strongest patterns and cycles in the economy and markets. Think about a clock pendulum. If you look at it once a second, it will always seem to be in the same position, motionless. You will miss the cycle. Likewise, if an economy regularly accelerates for 6 months and then symmetrically decelerates for 6 months, the yearly rate of change will be a constant, giving the false appearance that nothing is happening. It will miss the cycle. It turns out that the global economy does indeed regularly accelerate and decelerate - and that each half-cycle averages about 8 months. The strongest evidence of this very clear oscillation comes from the remarkably regular wave like pattern in the global bond yield, illustrated in the Chart of the Week and Chart I-5 and Chart I-6. Chart I-5The Global Bond Yield Has Shown A ##br##Regular Wave Like Pattern... Chart I-6...Which Is Easier To See ##br##When Detrended Furthermore, the acceleration and deceleration of bank credit flows - as measured in the global credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months. But crucially, a half-cycle length of less than a year means that a year on year analysis would miss this very clear oscillation. Hence, our analysis always uses the 6-month credit impulse (Chart I-7). Chart I-7The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Mini Half-Cycles Average Eight Months It is not a coincidence that the bond yield and bank credit impulse exhibit near identical half-cycle lengths. The bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop. A higher bond yield will initiate a mini down cycle. All else being equal, the higher cost of credit will weigh on credit flows. This will slow economic growth, which will then show up in GDP (and other hard) data. The bond yield will respond by readjusting down. In turn, a lower bond yield will then initiate a mini up cycle. And so on... But each stage in the sequence comes with a delay. For a change in the cost of credit to register with households and firms and fully impact credit flows, it clearly takes time. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows also takes time. Once you accept these assumptions of internal regulating feedback combined with delays in economic response, the economy has to be a naturally-oscillating system whose half-cycle length depends on the delays in economic response. And the important point is that these delays have little connection with nature's cycles. For those who are mathematically inclined, Box I-1 shows the differential equations which define the economic mini-cycle and its half-cycle length. Box 1The Mathematics Of Mini-Cycles Still, some commentators counter that credit flows don't just depend on the cost of credit. They also depend on so-called "animal spirits" - optimism or pessimism about the future. These commentators point to sentiment and survey data which show that animal spirits have soared. Our response is yes, for credit flows, heightened animal spirits in isolation are indeed a tailwind. But any rise in the cost of credit is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from the higher cost of credit. It is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy. We would suggest that the tailwind from heightened animal spirits has been countered by an even stronger headwind - the sharpest proportional rise in borrowing costs for at least 70 years (Chart I-8). Chart I-8The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! As anticipated in our 16th February report The Contrarian Case For Bonds, incoming GDP data from the world's largest economies - the U.S., U.K. and France - now confirm this. First quarter growth (at annualised rates) sharply decelerated to 0.7%, 1.2% and 1.0% respectively. And this is not just about so-called first quarter "residual seasonality" as 6-month growth rates have also lost momentum. The global credit impulse is 4 months into a mini-downswing; the global bond yield is 2 months into a mini-downswing. Previous half-cycles have averaged 8 months, with the shortest at around 5 months. Hence, we feel it is somewhat premature to position for the next mini-upswing. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The rally in Portuguese sovereign bonds appears technically overextended. Go short Portuguese sovereign 10-year bonds versus Spanish sovereign 10-year bonds with a profit target and stop loss of 2.5% . For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Chart 1European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... Chart 3...Brexit And Trump ##br##Should Not Be A Surprise Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead Chart 15Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals Chart 16Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Chart 18Fueling The Populist Fire Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency Chart 21Constraints On The Sunshine Policy In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Chart 39Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 Table 2Islamist Politics A Real Risk For Jokowi He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.