Economy

Highlights Are Markets Too Pessimistic On U.S. Growth & Inflation? What Is China’s Economic Pain Threshold To Trigger A Policy Response? Have Central Banks Become Less Concerned About Financial Markets? Feature Happy New Year! 2019 has started much like 2018 ended, with elevated global market volatility. The combination of more evidence of slowing global growth – fueled by spillovers from U.S.-China trade tensions – and central banks perceived to be overly hawkish has crushed investor sentiment. Money has flooded out of risk assets like equities and corporate debt and shifted into the traditional safe haven assets – government bonds, surplus currencies like the Japanese yen and even gold. U.S. equities and credit, which had been a refuge from the global market weakness for much of last year, have underperformed sharply as markets have moved to price in the global economic softness reaching U.S. shores. These market trends obviously run counter to our recommended positioning for overall portfolio duration (below benchmark) and credit exposure (neutral overall, favoring the U.S. over Europe and Emerging Markets). Yet we advise staying the course with our recommendations, as market pricing has become too pessimistic relative to likely global growth and inflation outcomes. The bulk of the recent decline in global bond yields has come from falling inflation expectations, which have been linked to the sharp fall in oil prices seen in the final months of 2018 (Chart of the Week). This is shown in Table 1, which presents the breakdown of the decline in the 10-year benchmark government bond yields for the major developed markets since the peak in U.S. Treasury yields back on November 8. Real yields have fallen by a more modest amount than inflation expectations in most countries, even with the pullback in cyclical indicators like the global PMI. Expected 2019 rate hikes are now fully priced out of money market curves, most notably in the U.S. Chart of the WeekSlowing Growth Is Not Why Yields Have Plunged   Table 1Decomposing 10-Year Yield Changes Since The November 2018 Peak In our view, there are three vital questions regarding the recent market turbulence that must be answered before determining the appropriate global fixed income investment strategy over the next 6-12 months. The answers lead us to maintain our current recommendations on duration, country allocation and credit exposure, even with the recent market turbulence. 1) Are Markets Too Pessimistic On U.S. Growth & Inflation? The December reading for the U.S. ISM Manufacturing purchasing managers’ index (PMI) released last week showed the largest single month deceleration since 2008 (Chart 2). All the main subcomponents of the ISM index fell, including the New Orders and Export indices which are now close to falling below the 50 threshold (Chart 3). Coming on the heels of China’s PMI dipping below 50, markets became more worried that the mighty U.S. economy was being dragged down to the weaker pace of growth seen outside the U.S. Chart 2Decomposing 10-Year Yield Changes Since The November 2018 Peak   Chart 3U.S. ISM Overstating U.S. Economic Weakness Yet when looking a broader array of U.S. indicators, the domestic economy still appears to be in good shape, albeit with some lost growth momentum. Consumer confidence remains solid, employment growth is accelerating, household incomes are growing at a faster pace and the personal savings rate remains elevated – all of which provide support for a faster pace of consumer spending (third panel). At the same time, the U.S. Conference Board leading economic indicator is still pointing to a healthy above-trend pace of GDP growth in 2019. U.S. Treasury yields have fallen to levels consistent with the drift lower in the ISM index (top panel), with the market now discounting one full 25bp rate cut to occur within the next twelve months. That will not happen given the tightness of the U.S. labor market and persistence of underlying domestic inflation pressures. The robust December gain reported in last Friday’s U.S. Payrolls report (+312k) may have surprised the markets, but our U.S. Employment Growth model had been signaling a faster pace of job growth for the past several months (Chart 4). The year-over-year growth in Average Hourly Earnings rose to 3.2%, the highest level in nearly a decade. With the overall unemployment still at a historically low 3.9% as labor demand is increasing, wages are likely to remain under upward pressure in the next 6-12 months. Chart 4U.S. Employment & Wages Are Accelerating Given this backdrop of economic growth that is likely to remain above-trend throughout 2019, it will be difficult to generate a sustained downturn in U.S. inflation this year, even given the lagged impact of the strong U.S. dollar and lower oil prices. While some decline in headline inflation measures is inevitable in the coming months given the rapid pace and magnitude of the 2018 oil plunge, BCA’s Commodity & Energy Strategy team continues to see a positive demand/supply balance helping push oil prices back towards the $80/bbl level in 2019.1 That would ensure that any decline in headline U.S. inflation would be short in duration, and of far less magnitude than the move that occurred after the 2014/15 oil plunge given the more robust domestic inflation backdrop (Chart 5). Chart 5This Is NOT A Repeat Of the 2015/16 Deflation Scare A sober assessment of the U.S. economic and inflation data leads us to conclude that U.S. interest rate markets have swung too far to the dovish side. The inflation expectations component of U.S. Treasury yields is now too low, and the Fed rate cut that is now discounted in money markets will not materialize. Rate hikes are the more likely outcome, the repricing of which will put renewed upward pressure on Treasury yields. 2) What Is China’s Economic Pain Threshold To Trigger A Policy Response? Of the potential catalysts that could turn the current investor pessimism into optimism, signs of improving Chinese growth would likely top the list. China’s economy has lost considerable momentum, with year-over-year real GDP growth slowing to 6.5% in the third quarter of last year and higher frequency data showing a further deceleration in the fourth quarter. The profit warning issued by Apple last week, prompted by an unexpectedly sharp slowing of Chinese mobile phone demand, is a sign that Chinese consumer spending may be faltering. There are several causes for the growth slump, both domestic and foreign. Chinese authorities have been clamping down on domestic leverage given elevated private debt levels, while also taking action to reduce domestic pollution levels – policies that all have helped dampen industrial activity. More recently, and more importantly, the U.S.-China tariff war has started to have a real economic impact on the economy through slowing trade activity and diminished business confidence. Given the Chinese government’s perpetual interest in maintaining domestic stability by limiting any cyclical increases in unemployment, the incentive is there for policymakers to provide renewed stimulus to put a floor under economic growth. The last such boost came in 2015/16, when the Chinese government implemented an aggressive expansion of fiscal spending alongside monetary policy measures such as interest rate cuts, reductions in reserve requirement ratios and currency depreciation. That package was enough to cause a sharp reacceleration of the Chinese economy, but only after nominal GDP growth had fallen to an 16-year low of 6.4% at the end of 2015 (Chart 6). Chart 6Nominal China Growth Less Than 7.5% Should Trigger More Stimulus … Policymakers will likely be forced into action again in 2019 if nominal GDP growth, which hit 9.6% in the third quarter of 2018, falls back below 7.5%. Forward-looking economic measures like our Li Keqiang leading indicator and the export orders component of China’s manufacturing PMI suggest that weaker growth outcome could occur by mid-2019. China’s policymakers are likely to announce some form of stimulus in the first half of the year help counteract the growth slump, which could help boost global investor confidence (especially if it is accompanied by a new trade agreement with the U.S.). While Chinese policymakers are now under more pressure to provide stimulus measures, the tools available to them are more limited than was the case in 2015/16 (Chart 7). Interest rate cuts could happen if growth continues to fall more rapidly than expected, but that would create a burst in private sector leverage that policymakers would seek to avoid. The currency could also be weakened further, but the USD/CNY exchange rate is already back to near the 7.0 level reached in the 2016 devaluation. Chart 7...Atlhough Policy Options Are More Limited Than 2016 That leaves additional cuts in the reserve requirement ratio and increases in fiscal spending as the two most likely means for China to stimulate its economy in the coming months. Yet even the fiscal channel has limits, given the much higher starting point for the budget deficit today (3.7% of GDP) than in 2015 (2%). So while the trigger for a China policy stimulus will likely be reached by mid-2019, the magnitude of the stimulus will be nowhere near as large as the 2015/16 measures. This will help stabilize global growth expectations, but likely not by enough to provide a major boost to global commodity prices or export demand from emerging market countries that are heavily dependent on China. This leads us to remain cautious on emerging market credit exposure, as we prefer to own U.S. corporate debt instead where the growth/profit outlook is better. 3) Have Central Banks Become Less Concerned About Financial Markets? A popular market narrative of late has been that the Fed “made a mistake” with its last rate hike in December. A similar argument was made for the ECB choosing the end its Asset Purchase Program last month with inflation still well short of its target and European growth decelerating. The idea that central banks had fallen “out of tune” with financial markets has spooked investors who fear that policymakers are carrying out a pre-conceived plan to normalize monetary policy without any regard to financial markets. We find this to be a highly dubious conclusion. Central bankers still care about financial markets – or, more accurately, financial conditions – but the hurdle for policymakers to respond to falling asset prices is higher now than in previous years because of a lack of spare economic capacity. Simply put, any tightening of financial conditions must be large enough to trigger a slowing of growth to a below-potential pace, resulting in rising unemployment and weaker inflation pressures. That has not been the case – yet – in the major developed economies. Financial conditions indices (FCIs) – which measure the combined impact of equity prices, credit spreads and currencies – typically lead economic growth by 2-3 quarters. The latest selloffs in equity and credit markets in the U.S. and Europe, while significant, have not been large enough to push FCIs for those regions to levels that would be consistent with below-trend growth, using the 2015/16 episode as a reference point (Chart 8). Chart 8Tightening Financial Conditions Not Signaling Below-Trend Growth...Yet Financial conditions in the U.S. are much closer to that 2015/16 reference point than in Europe, where bond yields remain very depressed and the euro is still an undervalued currency. Yet the domestic U.S. economy is in a much better state than was the case in 2015/16, as discussed earlier in this report. It is highly likely that the level of the U.S. FCI that would trigger a move to below-trend U.S. growth is much different today than in 2015/16. In other words, it would take a bigger widening of U.S. corporate credit spreads, or a sharper selloff in U.S. equity values, to generate the same type of drag on U.S. growth relative to 2015/16. Yet U.S. interest rate markets have already responded as if there was no such change in the amount of FCI tightening that would result in a more dovish Fed policy. The U.S. money markets have gone from pricing three rate hikes in 2019 to one rate cut, while bond investors have largely neutralized their bearish Treasury duration positioning (Chart 9). Chart 9USTs Now Discounting Too Much Fed Dovishness That swing in sentiment on the Fed’s next move flies in the face of the underlying health of the U.S. economic data, as well as our Fed Monitor which continues to signal the need for more Fed rate hikes (Chart 10). Our other Central Bank Monitors tell a similar story (outside of Australia), with the Monitors signaling no need for easier monetary policy but with money markets pricing out any probability of a rate hike over the next year. This leaves global government bond yields exposed to any sign that global growth momentum is stabilizing, particularly with the inflation expectations component of bond yields also vulnerable to a rebound in oil prices (Chart 11). Chart 10Bond Yields Are Now Exposed To A Repricing Of Rate Hikes   Chart 11Bond Yields Are Now Exposed To A Rebound In Oil Prices Our conclusion is that financial conditions in the major economies have not yet tightened by enough to end the process of normalizing global monetary policy from the extraordinarily accommodative settings seen in recent years. In other words, bond yields have not yet peaked for this cycle.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, “Oil Volatility Will Persist: 2019 Brent Forecast Lowered to $80/bbl”, dated January 3rd 2018, available at ces.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Risk assets have had a rough go of it since we last published on December 17th: Equities have been through the wringer, spreads have widened sharply, and the 10-year Treasury yield has tumbled to an 11-month low. We don’t put much stock in the talk that the Fed is about to go too far, … : We still judge that the fed funds rate is comfortably shy of its equilibrium level. The economy will decelerate this year, but fiscal stimulus will keep it growing above trend. … and even if market-unfriendly policies merit a lower equity multiple, … : A bull market in Washington uncertainty is a recipe for a lower multiple, and there are no signs that policy uncertainty will ebb any time soon. … we think the time has come to put our cash overweight to work: Equities priced in a lot of bad news when the forward multiple fell below 14. If earnings hold up like we think they will, a recovery to the mid-15s would deliver a double-digit gain, and that merits an equity overweight relative to cash and bonds. Feature Thanks to Christmas Eve and New Year’s Eve falling on Mondays, we haven’t published since December 17th. A lot has happened in those three weeks, starting with the FOMC’s final 2018 meeting. As we’ve gathered our bearings and tried to set a course forward through the volatility, we’ve asked ourselves several questions about markets, policy and the economy. This week’s report reviews those questions, including the ones the clients we met three weeks ago might want to ask now. Is the expansion coming to an end? Not just yet; we still think it has at least a year to run. Following several uninspiring releases, the Atlanta Fed’s GDPNow forecast of real final domestic demand has slipped to 3.3% from 3.8%, but it’s still 3.3%. That may seem too good to be true this late in the cycle, but that’s what 100 basis points of fiscal stimulus can do when injected into an economy already operating at full capacity. The IMF estimates there’s still another 40 basis points of stimulus coming in 2019, and we expect that that infusion will be enough to stave off the next recession until 2020 or beyond. Is the Fed about to make a policy mistake? We do not think so. Although the neutral, or equilibrium, policy rate is only observable after the fact, research from the head of the New York Fed holds that the FOMC is not on the verge of breaching the neutral threshold. The widely-followed Laubach-Williams model estimates that the real neutral rate is between 0.75 and 0.875%, or 2.75-2.875% in nominal terms.1 Our internal equilibrium fed funds rate model sees even more breathing room – it estimates that the (nominal) equilibrium rate is around 3%, and that it will rise to around 3⅜% by the end of the year. U.S. equities have been hypersensitive to perceived inflection points in monetary policy throughout the sell-off, which began roughly after Jay Powell said in an October 3rd interview that interest rates were “a long way from neutral.” Interestingly, though, the money market’s expectations never really budged. At the time of the Powell interview, it was pricing in a December hike to 2.50%, and a 40% chance of one more hike to 2.75%. It would take the probability of a 2.75% terminal rate up to 80% in early November, but it was again calling for a 40% chance of 2.75% when we were on the road during the two-day December meeting. It now puts the odds of an additional hike at just 4%, and says the Fed will have cut rates once by the middle of next year (Chart 1). Chart 1According To The Money Market, The Fed's Done We do not know what is behind the money market’s obstinacy, but we see an economy that has far more accommodation than it needs. While we think it’s inevitable that the Fed will tighten into a recession – that’s life with a blunt monetary policy instrument that works with long and uncertain lags – we don’t think it is on the verge of doing so. Fiscal stimulus will ensure that the U.S. economy grows above trend again this year, and there are no imbalances in housing2 or the other cyclical segments of the economy that would make the expansion particularly vulnerable (Chart 2). Elevated rates of job openings (Chart 3, middle panel) and job quits (Chart 3, bottom panel) indicate that the labor market will continue drawing in workers (Chart 3, top panel), supporting consumption and growth. Chart 2No Signs Of Overheating, ...   Chart 3... And The Jobs Outlook Is Strong You aren’t still calling for four rate hikes this year, are you? Let’s call it three, now that the market-driven tightening in financial conditions (Chart 4) has already done some of the work of cooling off the economy. We take the Fed at its word when it says its actions are data-driven, and we don’t think that it will pile on when credit spreads have shot up to their 2015 oil-collapse/shale-patch-distress levels (Chart 5) and equity prices have swooned. If credit spreads retraced meaningfully, and equities went back to making new highs, four hikes might come back into play. Conversely, if spreads continued to widen and took aim at their 2016 peaks, two hikes might become more likely than three. Given our expectations for spreads (they will not approach 2015-6’s quasi-recession levels, but corporate leverage is too high to support material narrowing), and equities (the S&P 500 will be hard-pressed to eclipse September’s high), our base case is three hikes. Chart 4Tighter, Yes; Tight, No   Chart 5Spreads Say It's 2015-6, ... Have the economic fundamentals really deteriorated that much over the last three months? Not that we can tell. There have been some high-profile data disappointments here and there, like the punk manufacturing ISM release last Thursday, but the overall message has been positive, and Friday’s jobs report was consistent with an economy growing above trend. The economic surprise indexes have been declining since November, but they’re not at levels that are anywhere out of the ordinary (Chart 6). Our earnings-per-share model still sees robust growth for corporate earnings (Chart 7). Chart 6... But The Data Beg To Differ   Chart 7Earnings Will Decelerate, But They Won't Contract We are as discomfited by the prospect of new trade barriers as any other economists, and we have eyed the divergence between U.S. acceleration and rest-of-the-world deceleration with increasing wariness. Even for an economy as comparatively closed as the U.S., decoupling is only a temporary phenomenon. We tend to equate global activity with global trade, and generally view developing economies as especially dependent on trade. It is still early days, but we have found it mildly encouraging that EM activity and EM equities have been outpacing their DM equivalents. The growth backdrop can’t be that bad if the emerging markets are perking up. Do you still think the S&P 500 has yet to make its highs? Maybe, but we wouldn’t bet on it. We view stock prices, P, as the product of expected earnings, E, and the multiple investors are willing to pay for those earnings, P/E. If our confidence in the expansion is not misplaced, and corporate earnings match analysts’ consensus bottom-up expectations of $174, topping September 20th’s 2,930.75 closing high will require a multiple approaching 17. If analysts project year-over-year EPS gains across all of 2020’s quarters, E will rise over the course of the year, reducing the P/E expansion needed to make a new high, but an assault on the peak cannot succeed without a meaningful re-rating from today’s multiple in the 14s. Although multiple expansion has played second fiddle to earnings growth (Chart 8, middle panel) across the nine-and-a-half year bull market, it declined nearly 30% peak-to-trough in 2018, and was entirely responsible for the fourth-quarter sell-off (Chart 8, bottom panel). While we think the de-rating has gone too far, the last three months have persuaded us that a return to the 18.8 peak is too much to ask. Our working hypothesis is that the equity market has decided that Washington has become enough of an impediment that the market multiple has to come off a couple of points. Markets hate uncertainty, and the policy climate is flat-out unsettled: the principal architect and guarantor of the international postwar order repeatedly threatens to topple that order; the U.S.-China showdown does not appear to be nearing a resolution; and both political parties seem willing to sacrifice the economy to gain an advantage in 2020. In the absence of new deregulatory initiatives or tax cuts to balance out the broadly investment-unfriendly instincts of several of D.C.’s power players, a poisonous partisan climate and a dysfunctional administration can no longer be ignored. Chart 8Earnings Built The Bull Market; De-Rating Almost Wrecked It Okay, so what do you do now? We upgrade equities to overweight with the cash we raised in mid-June when we downgraded them from overweight to neutral. Although we wouldn’t bet on the S&P 500 topping 2,931, it doesn’t have to do so to generate alluring prospective returns. From a 2,500 starting point, a target of 2,750, or $174 earnings at a 15.75 multiple, would generate a 10% capital gain. If the economy holds up in line with our base-case expectation, it’s hard not to like U.S. equities at current levels. We were eager to put our cash overweight to work as we watched equities gyrate in October and November, but the combination of December’s valuation reset and the improved equity outlook from our Global Investment Strategy colleagues’ MacroQuant model encourages us to pull the trigger now. More money is made when conditions, or perceptions, go from terrible to bad than when they go from good to great. As the approaching earnings season redirects attention to the solid fundamental outlook, and the Treasury secretary stops taking actions that make investors wonder if conditions are far worse than they feared, there is a path for perceptions to improve. Chart 9Spreads Have Overreacted We continue to hold to our view that markets are underestimating the potential for inflation, making Treasuries vulnerable, especially at longer maturities. We reiterate our recommendation to underweight bonds via an underweight in Treasuries, and to hold interest-rate duration below benchmark in all fixed-income categories. We continue to recommend a neutral weighting in credit-sensitive fixed income, as the spread widening is incompatible with projected defaults (Chart 9), but we are not counting on meaningful spread compression this late in the cycle.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 From the spreadsheet containing updated estimates of the baseline model described in “Measuring the Natural Rate of Interest,” by Thomas Laubach and John C. Williams, published in the November 2003 Review of Economics and Statistics, located at https://www.newyorkfed.org/research/policy/rstar, and accessed January 3, 2019. 2 We discussed housing at length in the November 19 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar,” respectively, available at usis.bcaresearch.com.

Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, January 9th at 10 AM EST, when I will be discussing the economic and financial market outlook for 2019 and answering your questions. Best regards, Peter Berezin, Chief Global Strategist Highlights The lack of major financial and economic imbalances in the U.S., as well as the Fed’s ability to moderate the pace of rate hikes, reduce the risk of a vicious cycle where tighter financial conditions lead to slower economic growth and even tighter financial conditions. The scope for central banks to cut rates is more limited outside the United States. Imbalances are also greater abroad. Nevertheless, the news is not all bleak, with the recent rebound in China’s credit impulse being a case in point. We turned more bullish on risk assets following December’s post-FOMC equity sell-off. A moderately overweight position in global equities over a 12-month horizon is currently justified. While we continue to favor the U.S. over other bourses in dollar terms, our conviction level in this regional bias has decreased. Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. Outside Japan, global government bond yields will also increase in 2019. We are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. We are also taking profits on our March-2019 EEM ETF put for a gain of 104%. Feature Merry Crisis And A Happy New Fear Santa arrived early this year. The plunge in stocks allowed investors to buy some of the world’s premier companies at a mouthwatering 20%-to-30% discount to what they would have paid just a few months earlier. What a gift! Needless to say, most investors would not regard last month’s stock market performance in such a favorable light. But why not? One answer is that investors must mark their portfolios to market. Thus, even if the decline in equity prices raised future returns, it still implied a decline in present net worth. Yet, this cannot be the whole explanation, because if all investors expected stocks to bounce back quickly, they would not have sold in the first place. Clearly, many investors must have come to the conclusion that the stock market would not only go down but stay down. However, this presents a puzzle. The economic environment did not change that much in the weeks leading up to the October sell-off. Growth has slowed more recently (Chart 1), with this morning’s disappointing ISM manufacturing report being the latest example, but this appears to have been mainly a response to the souring market climate rather than the cause of it. Chart 1Tighter Financial Conditions Have Led To Slower Growth Reverse Causality? This raises an intriguing possibility: What if the drop in stock prices and jump in credit spreads that began in late September hurt expectations of economic growth by enough to justify a further discount in risk asset valuations? Such a “Financial Conditions Index (FCI) doom loop” is not just a theoretical construct. The last two U.S. recessions were both the products of burst asset bubbles — first the dotcom bubble and then the housing bubble. Could such a self-fulfilling vicious cycle be erupting again? If so, any rally in stocks or credit should be sold into, just as was the case in both 2001 and 2007. U.S. Fairly Resilient To A Doom Loop Fortunately, there are two reasons to think that such an outcome will not reoccur, at least not in the United States. First, as Box 1 explains, an FCI doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. That does not appear to be the case today. Unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart 2). Cyclical spending – the sum of residential investment, business capex, and expenditures on consumer durable goods – is also far below prior business-cycle peaks as a share of GDP (Chart 3). Chart 2The U.S. Private Sector Is A Net Saver Chart 3U.S. Economy: Cyclical Spending Is Still Restrained Despite recent releveraging in some categories, U.S. household debt has continued to decline in relation to the size of the economy. The ratio of personal debt-to-disposable income is now 34 percentage points below pre-crisis levels (Chart 4). Chart 4Household Leverage Is Below Its Peak U.S. corporate debt has moved in the opposite direction. Nevertheless, while the ratio of U.S. corporate debt-to-GDP has climbed to a record high, it is still quite low by global standards (Chart 5). Perhaps more importantly, corporate debt is generally held by non-leveraged institutions. If corporate defaults were to rise unexpectedly, the losses to lenders would not pose the same systemic risk to the financial sector as mortgage defaults did during the Global Financial Crisis. Chart 5U.S. Corporate Debt Is High, But It Is Higher Elsewhere The Fed’s Reaction Function It is not surprising that the stock market sell-off accelerated in early October following Fed Chairman, and failed golfer, Jay Powell’s comment that interest rates were “far from neutral.” We think that worries that the Fed will tighten too quickly are misplaced. Yes, monetary policy operates with “long and variable lags.” However, financial conditions, which lead growth, can be observed in real time (Chart 6). Chart 6Global Financial Conditions Have Tightened Most of the tightening in financial conditions since late September has been due to falling equity prices. Our baseline scenario envisions a gain of roughly 10% in the S&P 500 in 2019. A rebound in stocks of this magnitude will reverse most of the recent FCI tightening, thereby allowing the Fed to raise rates three times this year. But if equities continue to sag, the Fed will scale back further monetary tightening or even cut rates. The mere possibility of such a policy response reduces the odds of an FCI doom loop. A Mixed Bag Outside The U.S. The economic outlook is murkier outside the United States. Economic and financial imbalances are greater in the EM space and parts of Europe. Non-U.S. central banks also have less scope to respond to adverse shocks, either because of fears that looser monetary policy will spark capital outflows (as is the case in many emerging markets) or because of the presence of the zero-bound constraint on interest rates (as is the case in the euro area and Japan). Nevertheless, the situation is not that bad. EM assets have been fairly resilient over the past few months, at least in comparison to their developed economy counterparts (Chart 7). China’s credit impulse has actually perked up, an indication that while credit growth is falling, it is doing so at a slower pace. Chart 8 shows that the Chinese credit impulse is highly correlated with global industrial commodity prices. We still expect global growth to slow in the first half of 2019, but at this point, much of the slowdown has been discounted in asset markets. With that in mind, we are raising the stop on our short AUD/JPY trade to 10% and instituting a profit target of 15%. Chart 7EM Assets Have Been Outperforming Recently   Chart 8The Increase In China's Credit Impulse Bodes Well For Industrial Commodity Prices The Perils Of Discrete Decision-Making One of the annoyances of being an investment strategist is that you often feel compelled to take discrete views on where the markets are heading. Are you bullish, bearish, or neutral? Actually, it is usually just bullish or bearish because most people regard neutral views as lacking in conviction and insight. This incentive structure is counterproductive. Not only does it cause analysts to turn a blind eye to incoming data that may challenge their thesis, it disregards how professional investors actually operate. Successful investors scale into positions as the market gets cheaper and scale out as it becomes more expensive. Trying to time the bottom (or the top) with exact precision is futile. With that in mind, we are going to tweak the way we make recommendations going forward in order to improve transparency, accountability, and accuracy. Rather than simply stating whether we are bullish, bearish, or neutral, we will assign the main asset classes a subjective score between zero and one hundred, with 0-to-40 being bearish, 40-to-60 being neutral, and 60-to-100 being bullish. We will adjust the score in every publication. To add analytic rigor to this framework, we will also compare our subjective model score with that of our MacroQuant model. Where Things Now Stand We downgraded global equities last June, but moved back to overweight following December’s post-FOMC meeting sell-off, as valuations reached that rather blurry line at which a modest equity overweight was warranted. Our subjective score for global equities currently stands at 65%, above the model’s estimate of 50%. Our moderately bullish view reflects our expectation that global growth will stabilize by mid-year and monetary policy will remain accommodative, even if the Fed raises rates by more than what the markets are currently discounting. Tempering our enthusiasm is the recognition that the business cycle is getting long in the tooth – especially in the U.S. – and that global equity valuations, while far cheaper than they were a few months ago, are still significantly less favorable than they were near past market bottoms (Chart 9). Chart 9Global Equity Valuations Have Improved Regionally, we continue to favor U.S. stocks over other developed markets, and DM over EM more broadly. However, our conviction level on this view is not high, and we are prepared to revise it if it looks like global growth is accelerating, an outcome that would limit any further dollar strength (our subjective dollar score currently stands at 70%, below the model’s estimate of 92%). Reflecting our expectation of decent global equity returns in 2019 and our waning conviction to be underweight EM, we are taking profits on in our March-2019 EEM ETF put for a gain of 104%.  Please note that our view on EM is more optimistic than that of Arthur Budaghyan, BCA’s chief emerging markets strategist, who continues to see considerable downside risks to EM assets. For now, Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. We assign the 10-year yield a score of 30%, which is close to our model estimate of 32%. Accordingly, we are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. Core European bond yields will increase, reflecting diminished excess capacity in the euro area and the end of ECB net asset purchases. U.K. yields should also grind higher, as the odds of a soft Brexit (or no Brexit) improve. Only in Japan will yields remain contained, thanks to the BoJ’s ongoing yield curve control regime. We do not expect spread product to have a banner year, but the current yield pick-up should be sufficient to ensure that risky credit outperforms cash. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Box 1 The Analytics Of Doom Loops When will a tightening in financial conditions stemming from lower equity prices and higher borrowing costs lead to a vicious circle of slower economic growth and even tighter financial conditions? The answer depends on how sensitive economic growth is to financial conditions in relation to how sensitive financial conditions are to growth. Figure 1 shows two equilibrium schedules, one for the economy (EE) and one for asset markets (AA). Both schedules slope downward. The EE schedule is downward-sloping because easier financial conditions boost growth. If growth is too strong given the prevailing level of financial conditions, economic activity will slow (Panel A). The AA schedule is downward-sloping because equity prices tend to fall and credit spreads rise when growth slows. If equity prices are too high and credit spreads are too narrow for a certain level of growth, then financial conditions will tighten (Panel B). Suppose economic growth is not very sensitive to changes in financial conditions, perhaps because imbalances in the economy are limited (Panel C). Then changes in financial conditions will be fleeting: A decline in equity prices or a widening in credit spreads will not hurt growth very much, allowing the stock market and credit market to quickly normalize. In contrast, suppose that economic growth is very sensitive to financial conditions, so much so that the EE schedule is flatter than the AA schedule. In this case, the economy will be vulnerable to self-reinforcing booms and busts (Panel D). In particular, a small random jump from U to UI will send the economy careening towards a doom loop of ever-weaker growth and tighter financial conditions.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades