Developed Countries
The S&P health care equipment index has underperformed alongside most other long-duration sectors, but the share price ratio has reached a point where buying interest should emerge. Sales have been running at a healthy double-digit clip, and new order growth remains firm, providing conviction that the outlook remains bright. Even exports are contributing positively, despite the high level of the U.S. dollar. The IFO survey of German medical equipment demand suggests that a solid undercurrent of foreign uptake exists. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity. We reiterate our overweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, DHR, SYK, BDX, BSX, BAX, ISRG, EW, STJ, ZBH, BCR, HOLX, VAR.
The sudden economic exuberance following the Trump election victory has caused a flight out of traditional safe havens that looks to have gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis. The chart shows that forward relative returns have typically been very robust when the group trades at a discount to the market. What could go wrong? History shows that a period of stable and strong GDP growth can cause discounted valuations to persist. Pricing in such an outlook at this juncture is overly optimistic, given the unknown fallout from a strong U.S. dollar on the rest of the world, trade uncertainty, and potential financial strains in the heavily indebted corporate sector as a consequence of rising bond yields. Keep in mind that the consumer products has a positive correlation with the U.S. dollar (top panel). We would be buyers on recent share price weakness.
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights U.S. bond yields and the U.S. dollar will rise further. Consistently, EM currencies and local bonds will continue selling off. There is meaningful downside in EM exchange rates. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KOR, MYR, IDR, TRY, ZAR, BRL, COP and CLP. Within domestic bond portfolios, overweight low-beta defensive markets as well as Russia and Mexico. Our underweights are Turkey, South Africa, Malaysia and Indonesia. The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy. Feature Emerging market (EM) risk assets will likely continue to be driven by both rising U.S. bond yields and a strong U.S. dollar over the next two months or so. Beyond the next couple of months, the focus of the markets will likely switch to China: renewed weakness in growth and possible instability in its financial markets, with negative implications for China plays globally and for commodities prices in particular. The combination of these two negative forces will lead to a considerable drop in EM currencies in the next six months or so. In turn, EM currency depreciation will trigger broad liquidation of EM risk assets. BCA's Emerging Markets Strategy service believes that EM risk assets will continue to sell off in absolute terms, and underperform their DM/U.S. peers. EM Local Bonds The total return (including carry) index of JPM GBI-EM1 local currency bonds in U.S. dollar terms has rolled over at a critical resistance level (Chart I-1). The total return index of EM local bonds has also relapsed relative to the total return of 5-year U.S. Treasurys, failing to break above its long-term moving average (Chart I-1, bottom panel). Consistently, domestic bond yields have troughed at important technical levels in several key countries such as Brazil, Turkey, Colombia, Russia, South Africa and Malaysia (Chart I-2A and Chart I-2B). Chart I-1EM Local Bonds' Total ##br##Return In US$: Failed Breakout Chart I-2AHave EM Domestic ##br##Bond Yields Bottomed? Chart I-2BHave EM Domestic ##br##Bond Yields Bottomed? In short, EM local bonds are exhibiting negative technical dynamics that corroborate our downbeat fundamental analysis. Consequently, we believe the total return JPM GBI-EM index in U.S. dollar terms will drop to new lows for the following reasons: Currency swings are responsible for most of the fluctuations in EM local bond total returns. As we have elaborated numerous times and re-assert in this report, the outlook for EM exchange rates remains gloomy. Foreign holdings of EM local currency bonds are substantial (Table I-1). Even though there have been improvements in a few countries, current account and fiscal deficits generally remain wide in the majority of developing nations (Chart I-3A and Chart I-3B). In other words, a number of EM economies are still at risk from a slowdown in foreign funding. Table I-1Foreign Holdings Of EM Local Bonds Chart I-3ACurrent Accounts And Fiscal Deficits Chart I-3BCurrent Accounts And Fiscal Deficits Chart I-4U.S. And EM Local Yields Notably, the bar for exchange rate depreciation is very low in EM economies with current account deficits. It takes only a reduction in net capital and financial inflows - i.e., net outflows are not necessary - for these countries' currencies to depreciate significantly. As net foreign funding diminishes, exchange rates of countries with current account deficits should weaken and interest rates should rise in order to compress domestic demand, which in turn would equalize the current account deficit to net inflows in capital and financial accounts. Finally, the spread of EM local bonds (the yield for GBI-EM global diversified index) over duration-matched (5-year) U.S. Treasury yields has not risen much (Chart I-4). Heightened risks in EM currencies warrant higher local bond yield spreads over U.S. Treasurys. Bottom Line: Absolute return investors should stay away from EM local currency bonds. U.S. Bond Yields And The Dollar: More Upside We expect U.S./DM bond yields to keep rising as re-pricing in global fixed income markets continues. The decline in DM bond yields in recent years until the latest selloff was enormous, and some sort of mean reversion should not come as a surprise. Our bias is that this selloff will likely continue until sometime in January, when U.S. President-elect Donald Trump takes office. This riot in the bond market could, in retrospect, resemble a typical "sell the rumor, buy the news" pattern. In other words, by the time President-elect Trump takes office, a lot of bad news will already be priced into the U.S. bond markets, creating a buying opportunity. In our July 13 Weekly Report,2 we argued that: "In the U.S., the combination of a healthy labor market and a heavily overbought fixed-income market have created the backdrop for a material rise in U.S. interest rate expectations/bond yields. As U.S. rate expectations climb, the U.S. dollar should gain support. This in turn will create headwinds for EM currencies and other EM risk assets." Then, we reiterated this view in our July 27 Weekly Report: "Nowadays, there is little talk in the investment community about a bond bubble and the potential for much higher bond yields. Indeed, "lower for longer" has begun to dominate the investor lexicon. This is a sign that many G7 bond bears have likely capitulated. Investor consensus on bonds has become quite bullish, and many investors are long duration. When many bears capitulate, the odds of a market selloff inevitably rise. "Importantly, the increase in G7 bond yields might not be gradual as many expect because of the following: with yields at such low levels, bonds' duration is high and price changes become very sensitive to changes in yield... Such (large) price changes (drops) would amount to large losses for bond investors, and forced selling could intensify. As a result, the unwinding of long positions could be abrupt and volatile." For now, odds are that U.S. bond yields will rise further. Given global bond funds have seen massive inflows in recent years, the latest drop in prices of various bonds has been substantial and will likely trigger withdrawals and redemptions from bond funds, prompting forced selling. This is true for all types of bond portfolios, including DM government and corporates, EM credit (U.S. dollar bonds) and EM local currency bonds. U.S. bond yields are still low, even from the perspective of the past several years, and the market-implied terminal fed funds rate is still 80 basis points below the median projection of the Federal Open Market Committee's longer-run rate (Chart I-5). Given that U.S. interest rate expectations are not high at all, they will rise further (Chart I-6) as the uptrend in U.S. wages persists - driven by an already reasonably tight labor market (Chart I-7). Chart I-5U.S. Interest Rate Expectations Are Still Low Chart I-6U.S. Wage Growth Is Accelerating Chart I-7More Upside In U.S. Treasurys Yields Finally, the U.S. dollar will continue to be buoyed by rising U.S. interest rate expectations. Our composite momentum indicator for the broad trade-weighted U.S. dollar has bounced off the zero line (Chart I-8). This constitutes a strong technical confirmation of the durable bullish market trend in the dollar. Bottom Line: Odds are that the rise in U.S. bond yields is not over. As U.S. bond yields rise further, EM currencies and bonds will sell off. Long-Term EM Currency Trends We have several observations on the long-term performance of EM currencies and financial markets: In the long run, there is no guarantee that the majority of EM currencies will appreciate in real terms (adjusted for inflation differentials). In fact, even countries such as Korea and Taiwan - which have been very successful in their economic development and have tremendously grown their income per capita - have seen their real (inflation-adjusted) exchange rates depreciate over the past several decades (Chart I-9). The case for long-term appreciation in real terms is even weaker for exchange rates in countries that exhibit chronically high inflation rates and/or current account deficits. This has been true for many non-Asian EM currencies (Chart I-10). Chart I-8The U.S. Dollar Is ##br##In A Genuine Bull Market Chart I-9Long-Term Currency ##br##Downtrends In Korea And Taiwan Chart I-10EM Currency Trends: ##br##A Long-Term Perspective Importantly, most losses to foreign investors in EM financial markets often occur via currency depreciation. This is even truer in the current bear market downtrend. The JPM ELMI+ currency total return index (including cost of carry) seems to be about to break down (Chart I-11). In EM ex-China, the real effective exchange rate is still elevated (Chart I-12). Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Chart I-11EM Currency Return With Cost ##br##Of Carry Versus U.S. Dollar Chart I-12Weak Productivity Means ##br##Further Currency Depreciation To limit the upside in domestic interest rates - both in bond yields and interbank rates - many developing nations' central banks will inject more local currency liquidity into their respective systems.3 This might help cap local interest rates, but is bearish for their currencies. The Turkish central bank has been among the most aggressive in this disguised money printing, and not surprisingly the value of its currency has collapsed (Chart I-13). There is no long-term history for EM currencies, as before 1998 most developing nations' exchange rates were pegged. Yet when one examines EM equities' relative performance against the S&P 500, it emerges that there is no single EM bourse that has outperformed U.S. stocks on a consistent basis in the very long run. Chart I-14A and Chart I-14B demonstrate that among 11 EM equity markets that have a long-term history, none have outperformed the S&P 500 over the past 30-35 years. Chart I-13Turkey's Central Bank Has Been ##br##Pumping Local Currency Into The System Chart I-14AEM Equities Versus The S&P 500: ##br##A Long-Term Perspective Chart I-14BEM Equities Versus The S&P 500: ##br##A Long-Term Perspective This goes to reveal that the starting point of underdevelopment and the mark "emerging" does not guarantee consistent outperformance even in the long run. In fact, EM's relative performance against the U.S. has followed multi-year cycles, and we believe the current bear market and underperformance is not yet over. While EM underperformance is long in duration, economic and financial adjustments remain incomplete. DM QE programs and China's still-growing credit bubble have delayed the adjustment. As a rule, the longer a financial or economic imbalance/excess lingers, the more protracted the adjustment will be. Bottom Line: EM exchange rates will continue depreciating. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP. For a complete list of our open currency and fixed-income trades please refer to page 18. Country Allocation For EM Local Bond Portfolios Chart I-15 demonstrates the relationship between developing countries' foreign funding requirements and their real (inflation-adjusted) local bond yields. The foreign funding requirement is calculated as the sum of the current account deficit and foreign debt service obligations over the next 12 months. We use inflation-linked (real) bond yields for markets where they are available. In other cases, we subtract the headline inflation rate from nominal bond yields to derive the real one. Chart I-15Real Bond Yields And Foreign Funding Requirements: A Cross Country Comparison The higher the foreign funding requirement, the higher the real yield must be to attract foreign capital, all else equal. On this diagram, the value pockets are Brazil (its real yield of 6.3% offers the best value by far), Indonesia, Russia and India. Domestic real yields in these countries are relatively high compared to their foreign funding requirements, which is a proxy for exchange rate risk. In contrast, Turkey, Chile, Colombia, Hungary and Malaysia have low real yields relative to their large foreign funding requirements. However, there are other factors that are shaping local yields. For example, Brazilian real yields look very attractive on this matrix because the latter does not account for public debt dynamics. The fiscal dynamics in Brazil are dreadful.4 On the contrary, Chilean local bonds appear expensive, but the country's fiscal outlook is very healthy. After considering all factors that affect local bond yields as well as incorporating the currency outlook, we recommend the following allocations: Overweight Korea, Thailand, Poland, Hungary, the Czech Republic, Russia and Mexico (Chart I-16). For investors who can invest in Chinese, Taiwanese and Indian local bonds, we also recommend overweighting these markets within an EM domestic bond portfolio. Underweight Turkish, South African, Malaysian and Indonesian local currency bonds (Chart I-17). We will publish our analysis on Indonesia soon. Stay neutral on domestic bonds' total return in U.S. dollar terms in Brazil (with a negative bias because of the considerable currency risk), Chile and Colombia (Chart I-18). Chart I-16Our Recommended ##br##Overweights In Local Bonds Chart I-17Our Recommended ##br##Underweights In Local Bonds Chart I-18Local Bonds ##br##Warranting A Neutral Allocation A Word On China's Commodities Frenzy Speculative fever is running high in Chinese commodities exchanges. Frenetic commodities trading in China has seen prices skyrocket of late (Chart I-19). Prices often rise a limit during a day. We have the following observations: This stampede into commodities is a reflection of rotating bubbles in China. Mania forces rotated from property to stocks, then to corporate bonds, and then back to housing, again. It seems to be shifting into commodities now. While the mainland's industrial sector and real demand for commodities have registered gradual improvement in recent months, the sharp spike in commodities prices largely reflects speculative activity much more than real demand. In fact, net imports of base metals have been flat for the past six years (zero growth in six years), and all swings have most likely been related to inventory cycles (Chart I-20). Chart I-19The Spike In Commodities ##br##Prices Trading In China Chart I-20China: Net Import Of Base Metals Like any speculative frenzy, this is momentum-driven and will one day crash. Timing the reversal is impossible. A lot depends on policymakers' willingness to confront this speculative bubble and investor psychology. Notably, onshore corporate bond yields and swap rates have recently begun rising. As in DM bonds, the rise in yields from very low levels is causing large price drops. As and if yields rise further, losses in corporate bonds will become considerable and investors (especially ones managing retail investors' money) will head for the exits, triggering liquidation. This, along with the eventual unraveling of commodities speculation poses substantial potential risk to global, or at least EM, financial markets. Bottom Line: The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy that will end badly. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments. 2 Please see Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016. 3 Please see "EM: Is The Liquidity Upturn Genuine And Sustainable?" Parts I & II, dated November 25, 2015 and December 2, 2015, respectively. 4 Please refer to the Emerging Markets Strategy Special Report, "Brazil: The Honeymoon Is Over," dated August 3, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
The S&P hotels index had been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels. REVPAR should be supported by decent consumer spending. Wage growth, and thus aggregate income, is perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power. Now that wage inflation has rolled over, the margin squeeze should go on hiatus. The bottom line is that an upgrade to neutral is now in order, locking in a profit of 3% on our underweight recommendation. Please see yesterday's Weekly Report for additional charts and analysis. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN.
Housing activity dipped this year. In response, building supply store sales cooled and analysts have been quick to slash both sales and earnings growth estimates for home improvement retailers. However, an overreaction appears to be occurring. There is little indication of a return to punitively deflationary industry conditions and we continue to be encouraged by the long-term outlook. Household formation is accelerating now that the unemployment rate is below 5%. Building permits are below average levels, even excluding the housing bubble period. Consumers have only recently become comfortable taking on mortgage debt, and first time buyers represent a rising share of total home sales. Banks are ready and willing to extend mortgage credit, unlike most other credit. Ergo, housing activity still has legs. While the backup in Treasury yields will no doubt make housing somewhat less affordable, even a 100 basis point rise would not push affordability back to average levels. Mortgage payments would still be well below the long-term average as a share of income, and effective mortgage rates are still extremely low. Therefore, we would not be surprised to see stable housing metrics in the coming months, despite the yield back up. We recommend buying into home improvement retail share price weakness, please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: BLBG: S5HOMI - HD, LOW.
Highlights Duration: The odds of further bond bearish catalysts emerging during the next 6-12 months are still quite elevated. Maintain below benchmark duration. Global Bond Strategy: The most likely candidates for another bond bearish catalyst would be an announcement of substantial fiscal stimulus from Japan and/or a hawkish policy shift from the Fed. Investors should remain overweight core Europe, underweight U.S. Treasuries and neutral on JGBs. U.S. High-Yield: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal. Feature In a U.S. Bond Strategy Special Report1 published in August we observed that, since the financial crisis, material increases in global bond yields have all been associated with a policy catalyst (Chart 1). We identified three such catalysts: the Fed's 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013, and the European Central Bank's (ECB) announcement of its own QE program in 2015. Now we can add the election of Donald Trump as a fourth catalyst that has spurred a tantrum in global bond markets. Chart 1The Four Post-Crisis Bond Tantrums The common factor that links all of these catalysts is that each causes the market to quickly re-assess its expectations about the future pace of monetary tightening. Interestingly, this re-assessment can be caused by either the announcement of a program that is perceived to be extremely stimulative or the announcement that monetary stimulus will be scaled back. Examples of the former include both the Fed's and ECB's QE announcements as well as the recent U.S. election. An example of the latter would be the 2013 taper tantrum. As in August, the goal of this report is to perform a quick survey of the major global economies in order to assess the likelihood that another bond-bearish catalyst emerges during the next 6-12 months. While we find it difficult to see a catalyst of the same scale as those shown in Chart 1, we assign high odds to the possibility that the announcement of fiscal easing in Japan will add to the bearish pressure on global bonds. We also assign high odds to the possibility that upside inflation surprises in the U.S. cause the Fed to adopt a more hawkish forward guidance, further increasing the bearish pressure on global bonds. We assign low odds to the possibility that ECB policy will contribute to the global bond selloff. U.S. Chart 2Fed Wants Breakevens To Head Higher The recent "Trump Tantrum" has sent yields sharply higher, and expectations priced into the U.S. bond market are now not far from the Fed's median rate hike expectations, especially at the short-end of the curve (Chart 2). In the U.S., the next most likely catalyst for sharply higher global bond yields would be the Fed signaling that it will adopt a quicker pace of rate hikes. Specifically, the Fed would need to cease revising its funds rate forecasts lower - which has been the pattern for the last few years - and start revising them higher. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, the Fed will take a more cautious approach. In fact, with inflation still below target (Chart 2, bottom panel) and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but that the median expectation will continue to call for only two more hikes in 2017. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed's inflation target. This corresponds to a range of 2.4% to 2.5% on the 5-year, 5-year forward TIPS breakeven inflation rate (Chart 2, second panel). Assuming that U.S. economic growth continues to accelerate into next year, as we expect, then the 5y5y TIPS breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely. In the meantime, while the "Trump Tantrum" is likely to take a pause in the near-term (next 1-2 months), it may not have run its course just yet. If U.S. growth is strong in 2017 and the Trump administration appears to be making progress implementing its more stimulative policies, then the Treasury curve will likely resume its bear-steepening trend in the first half of next year.2 Euro Area Chart 3Strong Growth, But Plenty Of Slack According to the OECD and others, including the European Commission and ECB, trend GDP growth in the Eurozone is below 1%. In fact, most estimates center around 0.7%. This means that as long as GDP growth is maintained above these levels we should expect the labor market to continue to tighten. At least for now, the data suggest that growth is likely to remain well above trend. Led by gains in both the services and manufacturing indexes, the euro area's composite PMI jumped from 53.3 to 54.1 in November. The composite PMI has a good track record of leading European GDP growth (Chart 3), and the current reading is consistent with GDP growth of 2%. Despite strong growth, the ECB's policy stance is likely to remain accommodative for quite some time and is unlikely to spur a global bond tantrum within our 6-12 month investment horizon. The fact that core inflation remains below 1% (Chart 3, panel 3) tells us that the output gap in the euro area is still very wide. It will take a prolonged period of strong growth for the output gap to close and for inflationary pressures to mount. In prior cycles inflation has not begun to accelerate until the unemployment rate was below 9% (shaded regions in Chart 3). An announcement from the ECB that it will cease its asset purchase program because the economy has made adequate progress toward its economic and inflation goals would likely spur a large rise in global bond yields. However, this is unlikely to occur until the unemployment rate is below 9% and inflation is in an uptrend. As we argued in a recent Global Fixed Income Strategy report,3 the ECB will be able to alter the rules regarding the quantity of bonds available for purchase as is necessary to keep the program in place. Japan The Bank of Japan (BoJ) recently switched to a policy framework that involves targeting a level of yields as opposed to a quantity of purchases. In our view, this sends a pretty strong signal that monetary policy is close to being exhausted and that fiscal policy must take up the baton of Abenomics. While the timing and amount of any additional fiscal spending is not clear, it is probably necessary if policymakers are serious about reaching their 2% inflation goal. Chart 4Policy Action Required In Japan At present, the Japanese Diet is currently deliberating the third revision to the second supplementary budget and government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. While any fiscal measures would not spur an increase in nominal JGB yields (because the BoJ will retain the cap), they would spur an increase in inflation expectations and a decline in real yields (Chart 4). We also think that the reflationary impulse would be felt by bond markets in the rest of the world, and that large enough fiscal stimulus from Japan would pressure global bond yields higher even though JGBs remain capped. Admittedly, the cap on nominal JGB yields would limit the contagion from Japanese fiscal stimulus to the rest of the global bond market. As would the impact of a depreciating yen relative to the euro and U.S. dollar. However, we also suspect that the shift toward greater fiscal stimulus in both the U.S. and Japan would cause investors to revise their global growth expectations higher, and that this impact would dominate in terms of the impact on global bond yields. Investment Conclusions The odds of further bond bearish catalysts emerging during the next 6-12 months remain quite elevated. The most likely candidates would be an announcement of substantial fiscal stimulus in Japan and/or a hawkish policy shift from the Fed. The ECB is unlikely to contribute to the bearish pressure on global bonds during the next 6-12 months. As such, we continue to recommend a below benchmark duration stance on a 6-12 month horizon. In global bond portfolios, investors should remain overweight core Europe, underweight U.S. Treasuries and neutral JGBs. Valuation & Expected Returns In U.S. High-Yield A commonly used tool for assessing value in the high-yield bond market is a default-adjusted spread. That is, we formulate an expectation for default losses during our investment horizon and compare it to the spread that is currently on offer. If the current spread is elevated compared to our expectation for default losses then the default-adjusted spread is high and we would see good value in high-yield bonds relative to equivalent-duration Treasuries. This week we examine two different formulations of a default-adjusted spread for the U.S. high-yield market and test how well each corresponds to excess junk returns. The first measure we look at is a true ex-ante measure. It relies only on data that are available in real time, and can therefore be used as part of a trading strategy. Specifically, our ex-ante default-adjusted spread is calculated as the average option-adjusted spread from the Bloomberg Barclays U.S. High-Yield index less an expectation of default losses for the subsequent 12 month period. Expected default losses are calculated by taking the Moody's baseline forecast for the U.S. speculative grade default rate during the next 12 months and multiplying it by 1 minus our forecast of the recovery rate for this same period. We forecast the recovery rate based on its historical relationship with the default rate. The second measure we examine is an ex-post default-adjusted spread. In this case we look at the average spread of the index less actual default losses that are realized during the subsequent 12 months. As such, this measure can only be calculated after the fact. Comparing the ex-ante and ex-post measures, we see that both tend to reside within a range of 200 to 300 basis points. However, the ex-post measure periodically shows a negative value while the ex-ante measure is more often above 300 bps (Chart 5). This tells us that when forecasting default losses it is more common to underestimate default losses, rather than overestimate them. Chart 5Distribution of Default-Adjusted Spreads Over Time The next thing we look at is how closely each measure aligns with high-yield excess returns (Charts 6 & 7). Our ex-ante measure explains 34% of the variation in high-yield excess returns since 2002 (when our sample begins). Predictably, the ex-post measure, which removes the error surrounding the default loss forecast, explains a greater proportion of the variation in excess junk returns (53%). Our sample period is also longer for the ex-post measure, beginning in 1995. Chart 612-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 712-Month Excess High-Yield Returns Vs. ##br##Ex-Post Default-Adjusted Spread (1995 - Present) The current average option-adjusted spread for the High-Yield index is 459 bps. If we incorporate the Moody's baseline forecast for the default rate during the next 12 months (4.1%) and our forecast for the recovery rate (39%), then we calculate an ex-ante default-adjusted spread of 210 bps. Using the relationship in Chart 6, this translates into an expected 12-month excess return of -26 bps. If we assume there is no error in our forecast then we can use the relationship in Chart 7. In that case, our expected 12-month excess return would be +55 bps. Of course, that exercise imposes a linear relationship between excess returns and the default-adjusted spread and doesn't consider that there is considerable variation in actual excess returns around this trendline. For that reason, in Charts 8 & 9 we split both our default-adjusted spread measures into intervals of 50 basis points. For each interval we display the average 12-month excess return along with a 90% confidence interval for where those returns are likely to fall. Chart 812-Month High-Yield Excess Returns & 90% Confidence Intervals: ##br##Ex-Ante Default-Adjusted Spread Chart 912-Month High-Yield Excess Returns & 90% Confidence Intervals:##br## Ex-Post Default-Adjusted Spread Specifically, the blue dots in Charts 8 & 9 show the 12-month excess return that is earned on average when the default-adjusted spread falls into a particular interval. The top and bottom edges of the vertical lines correspond to the upper and lower limits of the 90% confidence interval. More statistics related to the 12-month excess returns that have been observed when the default-adjusted spread falls into a specific interval can be found in the Appendix to this report. The main message from these charts is that a default-adjusted spread below 100 bps is a powerful sell signal, while a default-adjusted spread above 350 bps is a powerful buy signal. Between those two thresholds the signal is less clear. Bottom Line: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal, but is consistent with small positive excess returns. Our inclination is to remain cautious on U.S. high-yield for the time being, but to look for opportunities to upgrade from more attractive valuations. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com Appendix Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Fixed Income Sector Performance Recommended Portfolio Specification