Developed Countries

Highlights As central banks continue to push on a string for 2 percent inflation, it will underpin the valuation of equities and other risk-assets. So long as the global 10-year bond yield remains well below 2.5 percent, equity market sell-offs will be limited to corrections rather than an outright bear market. Within bonds, steer towards those where the monetary policy toolbox is not depleted, namely U.S. T-bonds. Within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the yen and the euro. Expect an early U.K. General Election whose result is extremely difficult to call. Until this fog of U.K. political uncertainty clears, steer clear of the pound and go long the international FTSE100 versus the domestic FTSE250.   Dear Client,   In lieu of the next weekly report I will be presenting the quarterly webcast on Tuesday 6 August at 10.00AM EDT, 3.00PM BST, 4.00PM CEST, 10.00PM HKT. Be sure to join me.   Dhaval Joshi Feature How Central Banks Have Misunderstood Inflation Chart Of The WeekInflation Expectations Just Track Actual Inflation Central banks continue to obsess about their failure to achieve inflation of two point zero (Chart I-2). The irony is that they should be rejoicing from the rooftops, because the major developed economies have all now reached the holy grail of price stability. Central banks have misunderstood price stability because they have defined it over-precisely in terms of econometric models and mathematics, when the way we actually perceive it has as much to do with psychology and physiology. Chart I-2Failing To Achieve Two Point Zero The human brain cannot distinguish inflation rates between -1 and 2 percent, a range we just perceive as ‘price stability’. As an example, if a loaf of bread costs 77 pence today, most people – myself included – would not perceive the difference between it costing 70 pence five years ago (2 percent inflation) or 73 pence (1 percent inflation). Compounding the perception difficulty is quality improvements. If the ingredients and nutritional quality are better today, then the price of the loaf may actually have gone down! Yet central banks persist in thinking of inflation within a linear spectrum which they can nail to one decimal place. Even now, Draghi talks about “survey-based inflation expectations at a level of 1.6/1.7 percent” as if the decimal point actually means something! What Draghi fails to recognise is that the human brain cannot perceive inflation to that level of mathematical precision. If I cannot distinguish between -1 and 2 percent inflation, then it is impossible for the central bank to change my inflation expectations within that range, because the entire range just feels like price stability to me. Therefore, my behaviour in terms of wage demands and willingness to borrow will also stay unchanged. And if my behaviour is unchanged, what is the transmission mechanism from -1 to 2 percent inflation? Chart I-3Inflation Expectations Just Track Actual Inflation This largely explains why monetary policy can take an economy from price instability into the range of price stability, but cannot fine-tune inflation within this broad range of price stability between -1 to 2 percent. The ultimate proof is that the market-based inflation expectations that central banks try to guide just track actual inflation (Chart Of The Week and Chart I-3). The problem is that central banks have created a rod for their own back. It is difficult for them to change their targets without gravely undermining their credibility. As Fed Chair Jay Powell points out “2 percent has become the global norm… saying that you’re going to change target – I wonder how credible that will be.” When Monetary Policy Is Depleted Monetary policy operates through the term structure of interest rates. The central bank sets short-term rates directly, and it establishes long-term rates through its forward guidance and QE tools. Other tools, like the TLTROs, simply ensure the effective transmission of the term structure to the banking system. Regarding QE, many people still believe that it is the central bank’s removal of bond supply that drives down their yields. This is plain wrong. The bond market sets the price of the QE transaction according to the signal it receives about future interest rate policy. For example, if QE implied rampant inflation down the road – and therefore higher interest rates – the act of QE would lift bond yields, perhaps considerably. In fact, the market interprets QE as a resolve to keep policy rates lower for longer and this is why it depresses yields.  At this week’s ECB policy announcement, expect the usual flannel and bluster. To achieve its 2 percent inflation target, “the Governing Council stands ready to act and use all the instruments that are in the toolbox”. The trouble is, once the term structure is at its lower bound all along its length – as it almost is in the euro area and Japan – the monetary policy toolbox is out of tools (Chart I-4 and Chart I-5). Chart I-4The Monetary Policy Toolbox Is Out Of Tools... Chart I-5...Once The Term Structure Is At Rock Bottom All Along Its Length The ECB’s increasing impotence is not something it wants to admit. As Upton Sinclair pointed out: it is difficult to get a man to understand something, when his salary depends upon his not understanding it! But to his credit, Draghi has at least hinted that the ECB toolbox is depleted, acknowledging that “in case of adverse contingencies, fiscal policy will have to play a fundamental role.” What Does This Mean For Market Strategy? To repeat, in a range of -1 to 2 percent, inflation expectations become insensitive to monetary policy. So in their obsession to achieve two point zero, central banks have pushed harder and harder on a piece of string. As a result, the experimental policy tools of our era have been forward guidance and QE, which have depressed bond yields to unprecedented lows (Chart I-6 and Chart I-7). Chart I-6Forward Guidance And QE... Chart I-7...Have Depressed Bond Yields To Historic Lows   Now we come to the crucial twist in the story. When bond yields enter a range of -1 to 2 percent risk-asset valuations become hyper-sensitive to monetary policy. We refer readers to previous reports in which we have extensively explained this dynamic. The upshot is that at ultra-low bond yields, the transmission to price inflation breaks down, but the transmission to risk-asset inflation increases exponentially1  (Chart I-8 and Chart I-9). Chart I-8Ultra-Low Bond Yields... Chart I-9...Have Lifted Equity Valuations To Historic Highs For market strategy, the good news is that as central banks continue to push on a string for 2 percent inflation, it will underpin the valuation of equities and other risk-assets. So long as the global 10-year bond yield remains well below 2.5 percent, sell-offs will be limited to corrections rather than an outright bear market.2  The other good news is that if there is no major dislocation in financial markets, economic downturns will be limited to down-oscillations rather than an outright recession. This is because, contrary to popular belief, the causality does not run from recessions to financial market dislocations; it almost always runs the other way, from financial market dislocations to recessions. The final strategic point is: within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the yen and the euro. Conversely, within bonds, steer towards those where the monetary policy toolbox is not depleted, namely U.S. T-bonds. Brexit Update Talking of flannel and bluster, Britain’s Conservative party has elected a new leader who, by default, becomes the new Prime Minister. But while the Conservatives and the U.K. have a new leader, as far as Brexit is concerned, plus ça change plus c’est la même chose. A new leader does not change the tight parliamentary arithmetic in which the Conservative/DUP pact now has a wafer-thin working majority of just four, likely reduced to just three after the Brecon and Radnorshire by-election on August 1. Neither does it change the EU27’s ‘red line’ to protect the integrity of the single market at the Republic of Ireland’s border with Northern Ireland. Meaning that either the whole of the U.K. or Northern Ireland must stay in a customs union with the EU27. Chart I-10When The Pound Weakens, The International FTSE100 Outperforms The Domestic FTSE250 Given these hard constraints we expect an early General Election whose result is extremely difficult to call. This is because the U.K.’s first past the post voting system is designed for a two party structure, and not for the four parties that are now in contention (five in Scotland).3 Until this fog of political uncertainty clears at least partly, steer clear of the pound. U.K. equity investors should go long the international FTSE100 versus the domestic FTSE250 (Chart I-10).    Fractal Trading System* This week we note that the blistering outperformance of the New Zealand electricity sector following the public float last year is technically extended and susceptible to a countertrend reversal. This trade is based on the 52-week fractal dimension and so has a potential duration of a year, longer than our normal trades. Short the New Zealand electricity sector versus the broader New Zealand market setting a profit target of 7 percent with a symmetrical stop-loss. In other trades, short Russia (MOEX) versus Japan (Nikkei) achieved its 5 percent profit target and is now closed. This leaves five open positions. 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.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1      Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.bcaresearch.com. 2      We define the global bond yield as the simple average of the 7-10 year government bond yields in the U.S., euro area, and China. A proxy is the simple average of the 10-year yields in the U.S., France, and China. 3      From political left to right, the parties are Labour, Liberal Democrat, Conservative, and Brexit. Scotland also has the Scottish National Party. Fractal Trading System 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. * 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. Cyclical Recommendations Structural Recommendations 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Neutral While in the previous Insight we highlighted a number of firming beverage industry operating metrics, soft drinks industrial production is still waving a yellow flag. In fact, relative output is contracting at the steepest pace in two decades (middle panel). A quick inventory check explains part of this softness. Beverage inventories continue to expand and this supply overhang will continue to weigh on output until inventory clears all channels (not shown). Finally, soft drinks stocks are trading at a 37% premium to the broad market and near the top end of the historical range. While this frothy valuation backdrop is worrisome, should earnings continue to surprise to the upside as we expect in the coming quarters then soft drink equities will grow into their pricey valuations. Bottom Line: Upgrade the S&P soft drinks index from underweight to neutral and lock profits of 5.5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, MNST.

Neutral As we continue shifting our portfolio away from cyclical and toward defensive exposure, we are upgrading the S&P soft drinks index from underweight to neutral, locking in a relative gain of 5.5% since inception. This defensive pure-play consumer goods sub-sector sparkles during economic slumps and heightened policy uncertainty (ISM shown inverted, second panel). Despite the broad-based slowing inflation data, both the soft drinks industry’s CPI and PPI measures continue growing at a healthy pace (bottom panel). PEP and KO results reflected this rising pricing power backdrop, as both companies had success in passing these price hikes down the supply chain. Moreover, relative beverage shipments have likely troughed, and similar to overall non-discretionary sales outshining discretionary retail sales (not shown), signal that a brighter demand backdrop looms. Importantly, our beverage industry activity proxy corroborates this message pointing to a recovery in relative profit growth (third panel). However, there are a couple of thorny issues that are still keeping us at bay and preventing us from lifting exposure all the way to overweight (please see the next Insight).  

Overweight-Downgrade Alert Airline stocks bounced off a critical support level on the back of encouraging profit results (top panel). Lower kerosene prices especially for the non-hedged carriers are flowing straight to the bottom line and a busy travel season signals additional gains in the coming months (jet fuel shown inverted, second panel). Not only domestic, but also international airfares are rebounding smartly and signal more revenue growth for airline stocks despite the grounding of the 737 MAX jet likely into 2020 (third panel). Sell side analysts have taken notice and the industry’s net EPS revisions ratio is on a slingshot recovery. While we continue to avoid rails (see the recent Insight) and remain neutral on airfreight & logistics, airlines are a positive exception within transports.   Bottom Line: Stick with an above benchmark allocation in the S&P airlines index, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.