Economy

Special Report

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Chart 6US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Special Report

Please note: There will be no European Investment Strategy report Monday, August 23. Our next report will be on Monday, August 30. Feature The past year has seen an unprecedented explosion of nonfinancial corporate debt as companies took on extraordinary leverage to weather the pandemic (Chart 1). This is a risk we recently highlighted in BCA Research European Investment Strategy, arguing that while euro area debt loads are not bad enough to make us turn bearish on European credit immediately, they still represent a concern for the future.  Rising debt servicing costs are also a risk, with aggregate euro area nonfinancial corporate debt servicing costs, as a percentage of operating cash flows, now pulling ahead of global peers. This increase has been led by France, where debt servicing costs now eat up a whopping 73.2% of cash flows. At the same time, value has steadily disappeared from European credit markets, with investment grade (IG) and high-yield (HY) spreads nearing 2018 lows (Chart 2). Our 12-month breakeven spread metric, which measures the amount of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, confirms this message. Ranked against their own history, IG and HY breakeven spreads are now at only their 16th and 13th percentiles, respectively. Chart 1Euro Area Debt Loads Are Rising Chart 2Value Has Disappeared From European Credit Against this backdrop, it pays to adopt a more cautious approach towards European credit. To that end, we are introducing our new and improved bottom-up Corporate Health Monitors (CHMs) for investment grade and high-yield issuers in the euro area. The CHMs are composite indicators of balance sheet and income statement ratios that are designed to assess the financial well-being of the overall non-financial corporate sectors in major developed economies. Before we jump into the message from our new European CHMs, however, it is important to review the methodology used to construct these indicators. A Quick Note On Methodology We begin by constructing a representative sample of euro area issuers to assess broader nonfinancial corporate health in the euro area. To accomplish this, we use the list of issuers from the Bloomberg Barclays IG and HY Corporate Bond Indices. Financials (mostly banks) are excluded from the calculations as they have very different balance sheet profiles, requiring a different set of metrics to properly assess the health of that sector. As an improvement of the previous euro area CHMs, we now use a dynamic sample of issuers that is updated every year. This allows us to account for the changing compositions of these indices over time, as issuers move up and down in quality, and are added or dropped from the index. This also accounts for the survivorship bias that arises as companies that go out of business are dropped from the sample. Note that our sample is static prior to 2012. Before this date, we do not have the data on index constituents needed to construct a dynamic sample. As of Q1/2021, the sample for the euro area IG CHM consists of roughly 200 issuers, covering 50% of the index, while the sample for HY consists of 50 issuers or so, covering only 25% of the index. As we can only get bottom-up data for publicly-listed companies, we are unable to include private companies that issue corporate debt but do not necessarily tap into the public equity market.    We then pull key financial statement ratios for these issuers on a quarterly basis. Specifically, we use the following six ratios: Profit Margins: Operating profits as a percent of corporate sales Return On Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBIT divided by value of interest expense Leverage: Total debt as a percent of market value of equity Liquidity: Total current assets excluding total inventories divided by the value of total current liabilities It is important to note that we are using the same financial ratios as the CHMs that we have previously published for other developed markets. This could prove useful later when we search for relative performance relying exclusively on CHMs. To construct the CHM, we pick the medians of the individual ratios for every quarter, which we then de-trend, by subtracting out the 12-quarter moving average, and standardize. Finally, we take an equal-weighted average of all six ratios to calculate the CHM. Using median ratios precludes excessive influence from outliers, while de-trending them introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Lastly, we calculate a version of the CHM that includes only domestic issuers, which allows us to look at the health of European nonfinancial firms in isolation. This is important, as foreign issuers make up roughly 60% of both the IG and HY samples. US issuers account for most of the foreign issuers for both samples, meaning that part of the message from our overall indicator is on US corporate health. However, we include our overall indicator for the sake of completeness. Unveiling Our New European Corporate Health Monitors Chart 3 presents the all-issuer and domestic issuer versions of our new European IG corporate health monitor. A negative indicator signals improving nonfinancial corporate health and vice versa. Both indicators have shown steady improvement since Q2/2020, with the domestic indicator peaking out in Q1/2020. However, there has recently been a notable divergence between the two, with domestic issuers recovering at a significantly slower pace. The recovery in the IG CHMs has been broad-based, with all component ratios showing an improving trend (Chart 4). However, domestic firms have clearly lagged behind, with the overall indicator especially outperforming on the return on capital, leverage, and interest coverage metrics. It is important when looking at falling leverage, however, to consider the “denominator effect” of rising share prices on equity market value. Chart 3Euro Area Investment Grade Corporate Health Monitor Chart 4Euro Area IG CHM: Component Ratios The HY monitor offers a more balanced picture between the domestic and all-issuer CHMs, with both indicators signaling a modest improvement in corporate health (Chart 5). This picture is confirmed by the constituent ratios, which, in the case of HY, tend to track more closely between domestic and all-issuer (Chart 6). Again, decreasing leverage contributed positively to the situation, while rebounding profits provided a strong boost to interest coverage ratios.     Chart 5Euro Area High-Yield Corporate Health Monitor Chart 6Euro Area HY CHM: Component Ratios Overall, the underperformance of domestic issuers on corporate health can largely be explained by a delayed reopening in Europe and weaker overall European fiscal stimulus response relative to the US. However, we expect this picture to change in coming quarters as vaccination rates continue to climb, European stimulus expands, and pent-up demand is released.  For both HY and IG, metrics such as profit margins or leverage have not yet returned to pre-Covid levels. While it may appear difficult to reconcile this with the highly optimistic readings from the CHM, we note again that the ratios are de-trended before they are incorporated into the CHM. That makes the CHM a better indicator of how corporate health is turning on the margin rather than in absolute terms.    Chart 7Euro Area: CHMs Vs. Spreads Our new CHMs undoubtedly provide an important signal on corporate health, but we are interested in the implication for corporate credit spreads. Chart 7 shows that the domestic issuer CHMs have been reliable at catching periods of major spread widening/tightening. Generally speaking, the year-over-year change in the CHM is a coincident indicator and can be used to confirm if movements in spreads are in line with underlying corporate fundamentals. Clearly, the recent narrowing in spreads has not kept pace with the drastic improvement in the CHM over the past two quarters. This likely reflects how close spreads are to post-crisis lows, meaning that they have little room left to fall regardless of how much corporate health improves. This asymmetry of returns, where credit has little to benefit from improving nonfinancial corporate health while remaining exposed to a deterioration, is a longer-term concern for investors. While spreads in level terms have been on a slow and steady narrowing trend this year, they are, on a rate of change basis, moving towards a more neutral level. This message will be confirmed by the CHMs in coming quarters as the monitors revert to the mean from their most recent optimistic readings. While Chart 7 displays the coincident properties of the indicators, we can also tune into the forward-looking aspect by looking at how spreads have performed historically over different time horizons given the levels of the CHMs. Table 1 presents the performance of both IG and HY spreads over the subsequent 3-12 month period when their respective CHMs were positive or negative. Table 1CHM Direction And Subsequent Spread Performance Over 3-12 Months For both IG and HY, there are a few key conclusions. Firstly, when the domestic-only CHM is negative, spreads tend to widen in the subsequent 3-12 months. Conversely, they narrow, on average, when it is positive. This reflects the mean-reverting property of our indicators. After the indicator has been positive for a while, indicating deteriorating health, it is naturally going to trend back towards zero. Spreads tighten in the coming quarters as a reaction to this marginal improvement in corporate health. The same relationship holds in the opposite direction.    On the whole, however, the domestic-only CHM is more reliable than the overall CHM as an indicator of whether spreads are going to widen/narrow. This discrepancy is most pronounced for HY, where the all-issuer version largely provides a misleading signal, with spreads usually continuing to narrow after the CHM is negative and widening after it is positive. One possible explanation for this is that European spreads are sensitive to European events, and since the overall CHM has a large presence of US corporate issuers, it does not properly reflect how investors should be compensated with regard to nonfinancial corporate health. Beyond just looking at the change in spreads following a positive or a negative reading on the CHMs, we can also see how spreads change when the CHMs fall into different ranges. Table 2 presents spread performance for periods when the CHM was within specific ranges: below -1, between -1 and 0, between 0 and +1, and greater than +1. This analysis makes an even stronger point on the mean reverting property of the indicator. When the CHMs reach extremely stretched positive (negative) readings, spreads tend to narrow (widen) a lot. The impact is also most pronounced over a 12-month horizon, with HY spreads narrowing, on average, a whopping 452bps twelve months after the CHM hits a level greater than +1. Table 2CHM Level And Subsequent Spread Performance Over 3-12 Months Bottom Line: Our new bottom-up European CHMs have been signaling a broad-based and consistent improvement in corporate health since Q2/2020. The CHMs are coincident indicators that can be used to confirm if changes in spreads are in line with fundamentals. On a forward-looking basis, stretched positive (negative) levels of the CHM indicate potential for future spread tightening (widening). Investment Conclusions While our CHMs are currently flashing a positive message on nonfinancial corporate health, there are some reasons to be cautious on European credit. Firstly, debt loads are at historically high levels in the euro area, a message confirmed by the bottom-up data shown in Charts 4 and 6. Spreads, on an absolute and breakeven basis, are also near post-crisis lows, implying meagre prospects for further tightening and are, on the other hand, exposed to any deterioration in corporate health. Lastly, the mean-reverting property of our CHM indicates that the monitors are likely to move back towards “deteriorating” territory on the margin, a historically negative sign for spreads. However, it is hard to recommend staying out of European credit at a time when fiscal and monetary policy are overly accommodative, and growth looks poised to surprise to the upside. The European Central Bank has already marked itself as one of the most dovish developed market central banks and will likely do “whatever it takes” to prevent a blow-up in spreads and the associated tightening in financial conditions. And currently, spreads still offer a decent yield pickup over sovereigns, even if they do not have much room to tighten. Thus, balancing the positives and negatives suggests it still makes sense to hold neutral exposure to credit within a European fixed-income portfolio, but adding to this exposure is now unwarranted. In the euro area, BCA Research Global Fixed Income Strategy is currently neutral on investment grade and overweight on high-yield credit.  Within high-yield, we recommend staying up in quality, favoring Ba-rated credit and avoiding lower tiers which will be hit first if corporate health deteriorates and do not offer adequate compensation for credit risk. Likewise, our European Investment Strategy recommends a selective approach, favoring sectors with more defensive risk profiles. Bottom Line: Even though there is some cause for concern on the horizon, it is too early to pivot out of European credit with the macro backdrop still accommodative. Remain neutral on euro area investment grade and overweight high-yield while avoiding riskier sectors and credit tiers within the high-yield allocation.               Jeremie Peloso,                         Associate Editor                          JeremieP@bcaresearch.com  Shakti Sharma, Senior Analyst ShaktiS@bcaresearch.com