Economy

Special Report

Highlights U.S. housing's immediate past will not repeat, ... : It is understandable that investors who lived through the financial crisis are acutely sensitive to any sign of trouble in housing, but none of the factors that helped precipitate the crisis are in place now. ... and its older history will only rhyme: Home construction slowdowns have a good record of signaling recessions, but residential investment's steadily waning share of GDP has chipped away at its influence. The current housing soft patch is not over, but it's unlikely to get much worse, ... : The rapid rise in mortgage rates sharply reduced affordability, but it still remains at a very comfortable level relative to history. Inventories of new and existing homes are very low, and the pace of new construction continues to run slightly behind household formation. Most importantly for the expansion, there were no construction excesses in this cycle that need to be worked off. ... so we don't think it's sending any broader signal about the economy: A tiny contraction in residential investment is not a harbinger of recession, nor is it an indication that monetary policy is already tight. Feature Desynchronization has been the name of the game in 2018. The U.S. economy, already ahead of its peers in putting the crisis in its rear-view mirror, has gotten an additional fillip from the fiscal stimulus package. Global growth, on the other hand, has been slipping. As Fed chair Jay Powell put it last week, the rest of the world is "gradual[ly] chipping away" at the U.S., but there "is not a terrible slowdown" in the global ex-U.S. economy. Global conditions have not slowed enough to get the Fed to interrupt its tightening campaign, but signs of softness outside of the U.S.'s borders have been popping up like mushrooms after the rain. With disappointments having been few and far between in the U.S., any pockets of weakness that do appear attract immediate attention. Against this backdrop, the slowing in housing - residential investment has now contracted for three consecutive quarters - is making some investors a little uneasy. We have spent a good deal of time within BCA debating housing's recent softness, its outlook, and its implications for financial assets and the economy, and clients are increasingly inquiring about our views. Housing's Recent Past Housing is top of mind for many investors because it was at the center of the financial crisis. Residential mortgages were ground zero of the credit bubble that systemically threatened the banking system. Wobbles in housing bring back unpleasant memories of the searing trauma that unfolded just ten years ago. With the dot-com mania and the financial crisis having occurred just a decade apart, the financial media, and many strategists, analysts and investors are on high alert for the next crash. The concerns are understandable, but conditions today are nearly the polar opposite of conditions in 2005 and 2006. There is nothing even remotely bubble-like about the current housing market. The critical weakness back then was the shunning of time-tested underwriting standards, as revealed by the homeownership rate. An average of just over 64% of households owned their own homes for the first three decades of the ownership series in a remarkably steady pattern,1 but a steady debauching of standards pushed the rate to above 69% at its peak (Chart 1, top panel). Chart 1Too-Easy Lending Standards ... The homeownership rate was built on a foundation of increasingly unserviceable mortgages (Chart 1, bottom panel). Prices surged (Chart 2, top panel), flippers flooded the market, and homebuilders ramped up production to meet the ensuing demand (Chart 2, second panel). When the music stopped, the housing market was left with unprecedentedly large inventories of unsold homes (Chart 2, third panel); the banking system's primary source of collateral was poised to suffer a body blow; and a hiring surge that played out over a decade and a half was unwound in just two years (Chart 2, bottom panel). Chart 2... Made Housing Unstable Housing In The Current Cycle Current conditions are much more stable. The homeownership rate is back to its time-tested levels. New housing supply has generally undershot the smoothed trend in household formations ever since the crisis ended (Chart 3, top panel). Inventories are strikingly low when adjusted for the overall size of the housing stock (Chart 3, middle panel). The vacancy rate is low (Chart 3, bottom panel), and there is no construction employment cliff. Most importantly from a stability perspective, the Basel III/Dodd-Frank regulatory framework makes it very difficult to replicate the reckless credit conditions that enabled the housing bubble. This cycle has been devoid of housing excesses. Chart 3Plenty Of Room For More Homes A broader historical context reveals that housing has been exerting steadily less influence on the economy across the entire postwar era. We have a good deal of sympathy for the argument that the postwar business cycle has been a consumption cycle, largely led by housing,2 but it's possible that the crisis marked housing's last hurrah as a driver of recessions. Residential investment's share of GDP exploded when pent-up demand was released upon the return of servicemen and women needing homes for their burgeoning families (Chart 4). The construction of the interstate system, and the network of subsidiary roads that sprang up to connect to it, facilitated the creation of the suburbs, and Levittown-style tract housing communities had to be built from scratch to meet the demand. Chart 4The Incredible Shrinking Impact Of Housing Activity The baby boom kept demand for more, and larger, houses going strong. Once grown themselves, the baby boomers helped keep household formation growth flush. The baby boomers are now net sellers, however, and will be at an increasing rate across the next couple of decades. The time trend of residential investment's share of GDP is stark, and demographics are poised to keep it going as long as the baby boomers are divesting their holdings. The bottom line is that we do not think housing is the business cycle this time around. It is a highly cyclical part of the economy, and its fluctuations will still be felt, but its influence on the overall economy has been steadily waning for 70 years, and it is not currently in a position to exert a powerful drag. It would be overstating matters to say that housing booms cause recessions, but they've been observed at the scene of the crime in every recession of the last 60 years except for the dot-com bust. In this cycle, the barely visible white area above the trend line in Chart 4 is nowhere near large enough to give rise to a big swing below the trend line, and inspire a patch of gray shading on its own. The ratio of housing starts to the existing stock of homes (Chart 5) reinforces the message of residential investment's declining contribution to overall output. The United States has been augmenting and/or replacing the existing stock of homes at a steadily diminishing rate for 60 years. Assuming that the rate of obsolescence has remained roughly constant, it seems that there has simply been less to build once the suburban frontier was settled. Even against the declining time trend, however, residential construction activity in this cycle has not revived enough to require a correction. Chart 5Tinkering Around The Edges We attribute the current softness to the backup in mortgage rates over the last twelve months. 100 basis points may not seem like the end of the world, but the rise in interest rates has been sudden, and it is entirely plausible to think that it has sent some marginal first-time buyers to the sidelines. The Housing Affordability Index is way below its 2013 peak, but remains quite high relative to its pre-ZIRP history (Chart 6, top panel). The sudden drop in the index has been a function of mortgage payments (Chart 6, second panel) as sudden moves almost always are - the median home price (Chart 6, third panel) and the median income series (Chart 6, bottom panel) are much less variable. Chart 6Mortgage Rates Drive Affordability We expect that rates will go still higher, but our bond strategists don't think it will happen any time soon. They see rates consolidating for a while as the economy digests the sharp move higher, and favorable year-over-year comparisons cool off inflation's upward momentum over the coming months. Our above-consensus view on the terminal fed funds rate is not housing friendly. Housing will have to contend with ongoing bond-market headwinds, but we don't expect another move of this magnitude will recur in such a concentrated time frame. Bottom Line: Housing may face a headwind from higher rates for at least another year, but a big drop-off in activity is not in the cards. There are no current cycle excesses that need to be unwound, and housing has become too small a part of the economy to induce a recession on its own. Housing Demand And The Fed Funds Rate Cycle The notion that mortgage rates are to blame for the housing soft patch raises some questions about our assessment of the monetary policy backdrop. Is it possible that a funds rate that's proximally related to a slowdown in housing demand is not impacting consumer demand for other goods or services, or corporate demand? Could there be multiple equilibrium fed funds rates? If not, is the housing soft patch a sign that the economy is actually in Phase II of the cycle, and not Phase I? We are unperturbed by the three-quarter contraction in residential investment, which one has to squint to see (Chart 7). We do not believe that housing demand has reached an inflection point; we simply think that prospective monthly mortgage payments have moved so fast that some buyers have temporarily stepped aside. Given that buying a home still looks quite inviting by the historical standards of the affordability index, conditions are not yet restrictive. Ex-the ZIRP era, the index had not exceeded 140 for more than three decades (Chart 6, top panel). If homes are still affordable relative to history, then housing would seem to support our equilibrium fed funds rate model's assessment that monetary policy remains accommodative. Chart 7Not Much Of A Downturn Yet We view the state of policy as binary for the economy as a whole, even if some activity is necessarily more rate-sensitive. While some marginal investment projects cease to generate positive prospective net present value any time interest rates rise, encouraging or discouraging activity is a universal condition. The broader investment-relevant question is whether or not our assessment that the fed funds rate cycle has not yet transited from Phase I to Phase II is correct (Chart 8). If the economy is still in Phase I, and will remain there for a year, our constructive take on the economy and financial markets still applies. If it's shifted to Phase II, however, the empirical record says investors should be paring back risk. Chart 8The Fed Funds Rate Cycle The preponderance of evidence supports the idea that we remain in Phase I. Real-time measures of activity remain robust. Credit performance remains very good, so banks are still eager lenders. Employment is surging, and a follow-up dose of fiscal stimulus in 2019 should keep all the plates spinning for another year. As macro investors, and students of cycles, we are as eager as anyone to recognize the inflection point as swiftly as possible, but the data series we follow do not indicate that it is approaching. We continue to abide by our equilibrium fed funds rate model's benign conclusion. Investment Implications Although housing's direct impact on GDP has steadily waned, it remains an important part of the economy, given how it feeds into several other elements of consumer demand. Three consecutive quarters of contraction in residential investment are worthy of notice, but such a run has occurred before without provoking a recession, and the contraction to date has been awfully modest in any event. We do not view the slowdown as the beginning of the end for the expansion. We also do not view it as a sign that monetary policy is tighter than we originally judged. We expect that the ongoing surprise over the rest of this cycle will be that the neutral fed funds rate is considerably higher than the market consensus expects. We therefore think that investors should continue to maintain benchmark exposure to risk assets while remaining underweight Treasuries and holding all bond exposure below benchmark duration. Since we think the expansion remains in place, supported by accommodative monetary policy, we view the recurring mini-scares provoked by data points like housing's soft patch as potential opportunities to put our cash overweight to work. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Over the 120 quarters through the end of 1994, a mean 64.3% of households owned a home, with a standard deviation of 0.6%. Only 22% of the quarterly observations were more than a standard deviation away from the mean, as opposed to the 32% predicted by the normal distribution. 2 Leamer, Edward E., "Housing IS the Business Cycle," NBER Working Paper No. 13428, September 2007. http://www.nber.org/papers/w13428

Dear Client, Barring any major market developments, we will not be sending you a report next week. Instead, I will be working with my colleagues on BCA's Annual Outlook, which will be published on Monday, November 26. The outlook will feature a wide-ranging discussion with Mr. X and his daughter Ms. X on the key themes that we see shaping global markets in 2019. Best regards, Peter Berezin, Chief Global Strategist Highlights The stock market correction has further to run. We would turn more bullish if global equities were to drop another 8% from current levels. A mundane economic identity - savings minus investment equals the current account balance - provides deep market insight into the workings of the global economy. The U.S. economy is suffering from a shortage of savings, which will push up interest rates and the value of the dollar. In contrast, China has a surfeit of savings. Rectifying this will require a weaker yuan. The political impasse between the EU and Italy over next year's budget will be resolved. However, the fact that Italy lacks a readily available outlet for its excess private-sector savings could spell doom for the euro area down the road. Feature The Correction Ain't Over Our MacroQuant model continues to signal downside risks for global equities over the coming weeks (Chart 1). The model is flagging a deterioration in a variety of leading economic indicators, both in the U.S. and abroad, which tends to be bearish for stocks (Chart 2). Global financial conditions have also tightened since the summer due to the rise in government bond yields, higher credit spreads, and a firmer dollar. Chart 1MacroQuant* Model Suggests Caution Is Still Warranted Chart 2Global Growth Indicators Are Deteriorating Sentiment remains reasonably upbeat, a bearish contrarian indicator. The November Bank of America Merrill Lynch Global Fund Manager Survey revealed that a net 31% of managers were still overweight global stocks. Past major bottoms in 2008, 2011, 2012, and 2016 all saw equity allocations fall into underweight territory. Strikingly, EM allocations rose in November, with a net 13% of fund managers overweight the asset class. This is in stark contrast to 2015 when a net 30% of fund managers were underweight EM stocks. We do not expect the correction which began in October to morph into a full-fledged bear market. Nevertheless, the near-term path of least resistance for stocks remains to the downside. We would only upgrade global equities to overweight if the MSCI All-Country World index were to fall another 8% from current levels, consistent with a price of $64 on the ACWI ETF. At that level, the forward P/E on the index would be back to 2013 levels (Chart 3). Chart 3A Valuation Reset A Key Macro Identity One of the first identities undergraduate economics students learn is S-I=CA: The difference between what a country saves and invests is equal to its current account balance.1 While it is easy to dismiss this identity as yet another abstract concept that only egghead economists would find interesting, it has real-world implications for investors of all stripes. To see this, it is useful to expand the identity a bit. Total savings is just the sum of private-sector and public-sector savings. Thus, we can write: Private-sector savings = fixed asset investment + government budget deficit + current account balance In other words, the savings that the private sector generates must either be recycled into investment, soaked up by the government through a budget deficit, or exported abroad via a current account surplus. This relationship always holds ex post. But what happens if it does not hold ex ante? Then "something" must adjust to make the relationship hold. In a normal environment, this "something" is interest rates. If there is a shortfall of private-sector savings - that is, if the right-hand side of the equation above exceeds the left-hand side - an increase in rates can restore the identity by encouraging private savings, discouraging investment, and potentially making it more difficult for the government to pursue an expansionary fiscal policy. Higher rates will also produce a stronger currency, leading to a deterioration in the current account balance. The exact opposite will happen if there is an excess of private-sector savings. What happens if there is excessive savings but the central bank cannot lower interest rates either because it lacks monetary independence - i.e., when a country has a currency peg - or because monetary policy is constrained by the zero lower bound on nominal short-term rates? In that case, employment will decline. One cannot save if one does not have a job that generates income. In practice, this can lead to a vicious circle where falling employment causes households to try to save more for precautionary reasons, while discouraging companies from investing in new capacity. The resulting increase in desired savings is likely to lead to further declines in employment. Keynes referred to this outcome as the paradox of thrift: A situation where one person's desire to save more leads to a collective decline in savings because aggregate income shrinks. Let's turn to what all this means for investors today. The U.S.: Trump's Fiscal Policy Is Inconsistent With His Trade Goals The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 5.6% of GDP next year. The results of the midterm elections are unlikely to change this outcome. While the takeover of the House of Representatives by the Democrats will preclude Congress from passing another round of tax cuts, our geopolitical strategists believe that there is a better than 50% chance that a bipartisan deal will be reached to increase infrastructure spending.2 They point out that Nancy Pelosi mentioned infrastructure five times during her election night address, without mentioning impeachment once. Recent data on U.S. capital spending has been on the soft side (Chart 4). Core capital goods orders have decelerated and capex intention surveys have come off their highs. Residential investment has also been weak, as reflected in declining housing starts and building permits. Chart 4Both Residential And Nonresidential Investment Have Softened We would tend to fade the weakness in capital spending (Chart 5). The ISM industrial capacity utilization rate is near cycle highs. Rising wages will incentivize firms to substitute labor with capital, leading to more investment spending. The downside risk to home building is also limited, given that residential investment stands at only 3.9% of GDP, well below the high of 6.7% reached in 2005. If anything, the U.S. is not churning out enough fixed capital, as evidenced by the fact that the average age of the capital stock has risen swiftly over the past decade. As my colleague Doug Peta likes to say, you don't get hurt falling out of a basement window. Chart 5Running Out Of Spare Capacity Meanwhile, the personal savings rate stands at over 6%, significantly higher than what one would expect based on its typical relationship with household net worth (Chart 6). Chart 6U.S. Household Savings Rate Is High Relative To Wealth The identity described at the outset of this report implies that the trade balance will necessarily deteriorate if the savings rate falls, investment rises, and the budget deficit remains elevated. If President Trump strikes a trade deal with China, he will have no one to blame for a larger U.S. trade deficit. Hence, he has little incentive to make a deal. Protectionism remains popular in the U.S. Midwest, the battleground on which the next presidential election will be fought. Democrat Sherrod Brown won the Ohio Senate race by 6.4% - a state that Trump carried by 8.1% - on a highly protectionist platform. Trump simply cannot afford to go soft on one of his signature issues. China: What To Do With Excess Savings? The slowdown in Chinese growth this year has been concentrated in domestic demand (Chart 7). Exports have held up well. In fact, Chinese exports to the U.S. are up 13% in dollar terms in the first ten months of the year compared with the same period last year. Chart 7China's Domestic Economy Is Weakening Unfortunately, judging from the steep drop in the export component of the Chinese manufacturing PMI, exports are likely to come under increasing pressure over the coming months (Chart 8). This makes it all the more important for the Chinese authorities to prop up domestic growth. Chart 8China's Export Outlook Is Dire China has historically stimulated its economy through debt-financed fixed-investment spending (Chart 9). This made eminent sense when China needed more factories, infrastructure, and modern housing. However, now that China has all this in spades, it is looking for different stimulus options. Chart 9China: Debt And Capital Accumulation Have Gone Hand In Hand Our formula reveals what those other options must be. If China wants to reduce investment spending to a more sustainable level, it must either boost consumption, increase the fiscal deficit, or raise net exports. Given a hostile export backdrop, it is therefore no surprise that the Chinese government has been cutting taxes, increasing social transfer payments, and letting the currency slide. The problem is that none of these other forms of stimulus are beneficial to the rest of the world, and in some cases, they may be quite detrimental. The rest of the world relies on Chinese investment, not Chinese consumption. Raw materials and capital goods comprise 80% of Chinese imports. China represents close to half of the world's demand for aluminum, copper, zinc, nickel, and steel (Chart 10). Whether it be services or manufactured goods, what Chinese households consume is generally produced in China. Chart 10China Is The Predominant Source Of Global Demand For Metals A weaker yuan will make the Chinese economy more competitive, but at the expense of other emerging markets. A weaker yuan will also raise the price of imported goods, leading to a lower volume of imports. The implication is that both the magnitude and composition of China's stimulus may disappoint. This week's much weaker-than-expected credit and money data - new CNY loans clocked in at RMB 697 billion in October, well below consensus expectations of RMB 905 billion - validates this view. Italy: Getting To "Yes" Is The Easy Part The showdown between Italy's populist leaders and the EU continues. The Lega-Five Star coalition government promised big tax cuts and generous increases in social spending. It is loath to backtrack on its campaign pledges so soon after the election. As long as there is no contagion from Italy to the rest of Europe, the EU has no incentive to back off. While it will never admit it, the EU establishment would love nothing more than to humiliate the Italians in order to dissuade voters across Europe from electing populist politicians. In the end, we expect the Italian government to give in to the EU's demands. Business confidence has plunged (Chart 11). The economy is again teetering on the brink of recession. Italy's banking system would be technically insolvent if the ten-year BTP yield were to rise above 4% based on a mark-to-market accounting of Italian bank holdings of government debt. Chart 11Italy: Is The Economy Heading For Another Dip? A political resolution to the ongoing crisis would provide short-term relief. However, it may not solve Italy's problems - indeed, it could exacerbate them. Italy's working-age population is shrinking (Chart 12). This has made companies reluctant to expand capacity. Meanwhile, households are busily saving for retirement. Their motivation to save more would only be amplified by the cuts to pension benefits that the previous caretaker government promised and that the EU is insisting be implemented. The overall private-sector financial balance - the difference between what the private sector saves and invests - reached a surplus of 5.1% of GDP in 2017 (Chart 13). Chart 12The Italian Workforce Is Shrinking Chart 13Italy: Private Sector Saves Too Much And Spends Too Little Our formula shows that counterbalancing this private-sector surplus will require a persistent government fiscal deficit or current account surplus. Italy's primary budget balance - its overall budget balance excluding interest payments - hit 1.7% of GDP in 2017 (Chart 14). This primary surplus is necessary to cover the 3.6% of GDP in interest payments that the government has to make, a number that will only rise if the ECB raises rates (hence, our high-conviction view that the ECB will have to keep rates low for years to come). Chart 14Italy Needs A Primary Budget Surplus Italy runs a modest current account surplus of 2% of GDP. However, its current account balance would be far smaller, and perhaps even negative, if the economy were operating at full employment since stronger domestic demand would suck in more imports. Italy would love to copy Germany, a country which habitually over-saves but exports its excess savings to the rest of the world through a gargantuan 8% of GDP current account surplus. Alas, achieving a larger current account surplus would require either a currency depreciation or productivity-enhancing structural reforms. The former is impossible as long as Italy is a member of the euro area, while the latter has proven to be wishful thinking for as long as people have talked about it. We do not expect Italy to default on its debt or jettison the euro in the near term. But when the next synchronized global downturn arrives - probably in about two years or so - all hell could break loose. Concluding Thoughts An economy facing a shortfall in savings is one where desired spending exceeds income. When the economy has spare capacity, such a savings shortfall is a good thing; it means more demand, more employment, and ultimately, more income. However, once spare capacity is soaked up, a shortage of savings will lead to higher inflation. The U.S. finds itself in the latter situation today. The output gap is fully closed, but growth remains above trend. As we have discussed in past reports, the Fed is likely to raise rates more than the market expects.3 This will lead to higher Treasury yields and a stronger dollar. With that in mind, we are raising our end-year target on our long DXY trade recommendation from 98 to 100, implying another 3% increase from current levels. In the absence of offsetting Chinese stimulus, a stronger dollar will put further pressure on emerging markets. EM equities will likely bottom in the first half of next year once the dollar peaks and global growth stabilizes. Until then, investors should overweight DM stocks relative to their EM peers. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 National savings, S, is equal to Y-C-G, where Y is national income and C and G are household and government consumption, respectively. Substituting this identity into the standard Y=C+I+G+X-M equation yields S-I=X-M. National income includes net foreign earnings. In this case, the trade balance, X-M, is equal to the current account balance. 2 Please see Geopolitical Strategy Special Report, "The 2020 U.S. Election: A "Way Too Soon" Forecast," dated November 7, 2018. 3 Please see Global Investment Strategy Weekly Report, "Bond Bears Maul Goldilocks," dated October 12, 2018; and "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. 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Highlights Global growth has not yet bottomed, this will provide additional support for the dollar. EUR/USD will be a buy once it dips below 1.1, as slowing global growth means that European activity will continue to lag behind the U.S. The dollar is not as expensive as simple metrics suggest. Fade any Sino-U.S. détente in Buenos Aires. The best vehicle to play a dollar correction remains the NZD. GBP volatility is peaking. Feature We have been on the road for the past two weeks, in the U.S. and in the Middle East. Exchanges with clients can reveal what the key narratives driving the markets are and where the walls of worries may lie. This week, we opted to share what have been the major questions plaguing clients minds. Question 1: Has Global Growth Bottomed? The short answer is no. While there are issues affecting Europe, such as Italian budget battles and idiosyncrasies in the German auto sector, the key impetus pushing global growth downward is China. The Chinese economy is slowing as Chinese policymakers are working to force indebtedness lower, and have therefore constrained access to credit, especially in the shadow banking system (Chart I-1). This has not changed. Chart I-1Chinese Policy Tightening In Action China's Deleveraging Is Not Over Yet It is also true that Chinese policy makers have been trying to limit the downside to growth. They have injected liquidity in the banking system, let the renminbi depreciate, and allegedly, supported a stock market spiraling downward under the pressure of margin calls. Moreover, fiscal policy is being eased, with income tax cuts pointing to a desire to support household consumption, especially spending on services. But none of these policy actions seems to matter for the world economy, at least for now. China impacts global growth through its imports, and non-food commodities, investment goods, machinery equipment and transportation goods constitute 85% of total Chinese imports. These goods are levered to industrial activity and the Chinese investment cycle. The latter in turn is levered to the Chinese credit cycle (Chart I-2). Hence, as long as China tries to reign in credit growth, Chinese imports will be under pressure. Chart I-2Slowing Chinese Credit Impulse Means Slower Chinese Imports What about the recent rebound in Chinese imports? Our China Strategist posits that it has been linked to front running of orders before the Trump tariffs enter into effect. The trend in credit growth remain poor. The October's money and credit numbers show that the China's total social financing grew at its slowest pace in 12 years, and money growth as well as traditional loan growth has also relapsed (Chart I-3). Hence, China doesn't have an appetite for credit yet. Chart I-3Chinese Credit Is Not Responding To Chinese Stimulus It is hard to fully know why the country's appetite for credit is slowing despite the expanding list of small measures implemented by authorities to support economic activity. On the one hand, it seems that lenders are reluctant to lend. On the other, the private sector does not seems hungry to spend either. As BCA's Emerging Market Strategy service highlighted, even the Chinese consumer is displaying a declining marginal propensity to consume, and retail sales as well as car sales are declining (Chart I-4).1 This suggests that China will continue to act as an anchor on global growth for the time being. Chart I-4Chinese Households Are Cautious Stresses outside of China also remain problematic for global growth. Emerging market financial conditions have tightened significantly. This will continue to act as a drag on global industrial activity (Chart I-5). In fact, the recent poor GDP numbers out of Germany and Japan, two nations highly levered to the global industrial cycle, confirm that the pain originating in the EM space is spreading around the globe. Chart I-5EM Financial Conditions Suggest Continued Downward Pressure On Growth Ultimately, since the U.S. economy is a low beta economy, even if U.S. growth downshifts in response to shocks to global growth, it is likely to slow less than the rest of the world. This explains why the dollar exhibits little constant correlation with U.S. growth, but a tight negative relationship with global growth (Chart I-6). Chart I-6The Countercyclical Dollar Hence, since we see little hope for an imminent bottom in global growth, additional dollar upside remains. Thus, we re-iterate our target for DXY at 100. Nevertheless, make no mistake, the easy gains in the greenback are behind us. The remainder of the rally will likely prove volatile. Question 2: Is The Growth Divergence Between The U.S. And The Euro Area Peaking? Will This Reverse The Dollar Rally? Economic data in the U.S. has begun to weaken, especially on the durable good orders and the housing fronts. Moreover, the recent core CPI data, which came in at 2.1%, was a disappointment. The strong dollar, higher interest rates, tighter financial conditions, and the potential hit to profits from falling oil prices all suggest that U.S. capex could slow. However, as Chart I-7 illustrates, Europe is slowing more than the U.S. Despite the rollover in the U.S. Leading Economic Indicator, the gap between the U.S. and the euro area LEI is in fact growing in favor of the U.S. This is because the U.S. is a low beta economy and it outperforms Europe when global growth slows, especially when the negative impulse emanates out of China (Chart I-8). Chart I-7U.S. Growth May Be Slowing, But It Is Still Outperforming... Chart I-8...Especially If China Does Not Pick Up Nonetheless, the Fed has already increased rates eight times this cycle and the market anticipates a bit more than two interest rate hikes in the U.S. over the next 12 months, while in Europe, rate expectations are much more muted. Will this slowdown in U.S. growth cause U.S. rate and yield differentials versus the euro area - which stand near historical highs - to fall, providing a welcome fillip for EUR/USD in the process (Chart I-9)? Chart I-9U.S. Spreads Are Wide We doubt it. First, three deep structural problems still hamper Europe: Italy still faces challenging debt arithmetic if interest rates rise quickly, which means that Italy continues to teeter close to the hedge of a Eurosceptic drama. European banks are still much weaker than U.S. ones and have a large amount of EM exposure, limiting their capacity to handle higher rates. Europe is far from a true fiscal union, which means that the job of supporting growth lies much more heavily on monetary authorities than in the U.S. This forces the European Central Bank to stay more dovish than the Fed. Second, once the cost of currency hedging is taken into account, the spread between U.S. and European bonds yields becomes negative (Chart I-10)! This suggests that unhedged U.S. yields can rise further versus European ones as U.S. hedged yields are not attractive. This means that yields and interest rates in the U.S. can remain high or even rise relative to Europe, making it attractive to buy the greenback for investors willing to take on currency risk. Chart I-10U.S. Hedged Yields Are Low Hence, we do not expect that the slowdown in U.S. growth will constitutes a major problem for the dollar. Instead, we are looking for EUR/USD to fall below 1.10 before buying the common currency again. Question 3: Is The Dollar Expensive? The answer to this question seems obvious. When looking at a simple purchasing-power parity model, the dollar does look very expensive (Chart I-11). However, valuing currencies is a much more complex question than just looking at PPP metrics. Once other factors are taken into account, the dollar trades in line with its long-term drivers (Chart I-12). The dollar might not be as expensive as PPP metrics suggest because the U.S. productivity growth is higher than in most other G10 nations, because neutral interest rates in the U.S. are structurally higher than in Europe or Japan, and because the U.S. current account deficit is stable despite a strong dollar as the U.S. morphs from an energy importer to an energy exporter. Chart I-11U.S. Dollar And PPP Is The Greenback Really This Expensive?   Chart I-12Maybe Not On a short-term basis, there is no evident misalignment in the USD either. The DXY dollar index trades in line with our short-term metrics, suggesting that until now, the bulk of the dollar rally this year was a correction of its previous undervaluation (Chart I-13). Furthermore, the dollar tends to peak at higher degree of overvaluations, and, if U.S. growth continues to outperform the rest of the world, the fair value of the DXY could rise further. Chart I-13No Short-Term Misalignment Question 4: Will Sino-U.S. Relations Improve After The Buenos Aires G20 Meeting? We are skeptical that Sino-U.S. relations will improve after the Buenos Aires meeting at the end of the month. The White House could delay the imposition of a third round of tariffs as well as the increase in the current tariff rate from 10% to 25%. Such actions would likely result in a temporary bounce back in risk assets and EM related plays as well as correction in the USD. However, President Trump has no incentive to make a full-blown trade deal with China right now. The midterm elections confirmed that the U.S. electorate is not pro-free trade and that the political apparatus in the U.S. is unified in fighting China. At the end of the day, China is a great scapegoat for the income inequality problem plaguing the U.S. Question 5: Will The Dollar Correct After Its Furious 2018 Rally? Our inclination is to think that there are short-term risks building up in the dollar, a topic we discussed at length three weeks ago.2 Namely, traders are now very long the dollar, and risk-on currencies have been rallying against the dollar despite the strength in the DXY. This suggests that the corners of the FX market most levered to global growth might be sniffing out a stabilization in global conditions. Indeed, the Chinese economic surprise index has improved (Chart I-14). While Chinese data has not meaningfully picked up, expectations toward China are very depressed. As such, a slowdown in the pace of deterioration could be interpreted as good news for global growth. The countercyclical dollar may correct. Chart I-14Are Expectations Toward China Too Depressed? We have not played the dollar correction risk through selling DXY or buying EUR/USD. Instead, we have bought the NZD against both the USD and the GBP. The beaten down kiwi would be the currency most likely to rebound if global growth conditions were to surprise to the upside, even if temporarily. This has proved to be the right call. We remain positive on the NZD for the coming two months. However, from a risk management perpectives we are closing our long NZD/USD trade at 4.8% profit. However, we doubt that any dollar correction is likely to morph into a genuine bear market. If global growth conditions were indeed to improve, this would give more ammo for the Fed to hike in line with its "dots". The market knows that and would revise upward the modest 60 basis point of hikes currently anticipated over the coming 12 months. As such, the resultant increase in real rates would likely hurt the still-fragile EM economies and cause a renewed tightening in EM financial conditions. This would in turn lead to additional slowdown in global growth and would support the dollar. Hence, our current positive predisposition toward the kiwi is temporary in nature. Question 6: Has The Pound Bottomed, Will GBP-Volatility Recede Anytime Soon? In September, we warned that the pound did not compensate investors adequately for the political uncertainty surrounding Brexit risks.3 Specifically, we were most worried about British domestic politics, not the EU side of the negotiations. However, because we believed that ultimately, either soft Brexit or Bremain would ultimately prevail, we refrained from selling the pound outright. Instead, we recommended investors buy the GBP's volatility. Today, Prime Minister Theresa May is in danger as two additional ministers resigned from her cabinet after she presented the Brexit deal that was hammered out with Brussels. The risk of a new election or a hard-liner Brexit Tory replacing her is growing by the minute. Markets are once again clobbering the pound, and GBP implied volatility is trading at level last seen directly after the June 2016 referendum (Chart I-15). Chart I-15Close Long GBP Vol Bets At current levels, the pound is now an attractive play for long-term investors. Additionally, while a new election is likely to cause more tremors into the pound, we are inclined to recommend investors close long GBP volatility trades as the British public is growing more disillusioned with Brexit. Our conviction is only growing that only the softest form of Brexit will be implemented. As a result, the risk-reward ratio from selling the pound or buying its volatility has now significantly deteriorated. We are closing our short GBP/NZD trade at a 6% profit in four weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, titled "On Domino Effects And Portfolio Outflows", dated November 15, 2018, available at ems.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Risk To The Dollar View", dated October 26, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Assessing the Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Both core inflation and core PCE came in below expectations, coming in at 2.1% and 1.6% respectively. However, Q3 GDP growth surprised to the upside, coming in at 3.5%. Moreover, nonfarm payrolls also came in above expectations, coming in at 250 thousand. The DXY index has been able to appreciate over the past three weeks. We maintain our bullish bias towards the dollar, given that despite its rise, this currency remains fairly valued. Moreover, we expect global growth to continue deaccelerating, as Chinese authorities continue to tighten. That being said, potential upside might be limited from current levels, as speculators are very long the dollar. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Core inflation increased and outperformed expectations, coming in at 1.1%. Moreover, Markit Services PMI also surprised to the upside, coming in at 53.7. However, Markit Manufacturing PMI surprised negatively, coming in at 52. EUR/USD has depreciated over that past three weeks. We remain bearish on the euro, given that we expect global growth to keep slowing, hurting export-driven economies like the euro area. Furthermore, Italian debt dynamics will continue to plague the Eurozone. That being said, if the euro were to fall below 1.1, we would tamper our bearishness. Report Links: Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The unemployment rate surprised positively, coming in at 2.3%. This measure also decreased from last month. However, housing starts yearly growth underperformed expectations, coming in at -1.5%. Moreover, overall household spending yearly growth also surprised negatively, coming in at -1.6%. Q2 GDP contracted and also came in below expectations, driven by poor capex growth. USD/JPY has also appreciated over the past three weeks. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings excluding bonus yearly growth surprised to the upside, coming in at 3.2%. However, core inflation underperformed expectations, coming in at 1.9%. Moreover, retail sales yearly growth also surprised negatively, coming in at 2.2%. After rising for the last three weeks, GBP/USD fell by over 1.5% on Thursday, after two ministers quit Theresa's May cabinet. While the headline risk remains large, especially as the U.K. could soon go through an election, we do not want to be greedy and our closing our long GBP-vol bets. We are also closing our short GBP/NZD bet. At current levels, GBP is now an attractive long-term play. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: Employment growth outperformed expectation, coming in at 32.8 thousand. Moreover, the participation rate also surprised to the upside, coming in at 65.6%. Finally, the unemployment rate also surprised positively, coming in at 5%. AUD/USD has risen by 3.39% the past 3 weeks. We are inclined to fade this rally as the poor outlook for the Chinese economy could soon transform these strong Australian economic results into much more disappointing numbers. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Employment growth outperformed expectations, coming in at 1.1%. Moreover, the participation rate also surprise to the upside, coming in at 71.1%. Finally, the unemployment rate also surprised positively, coming in at 3.9%. NZD/USD has risen by more than 5.5% the past 3 weeks. The NZD continues to be one of our favorite currencies in the G10, given that rate expectations continue to be very low, even though economic data has strengthened. Moreover, food prices, dairies in particular have limited downside from here, especially as they are not very exposed to China's policy tightening. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: The net change in employment outperformed expectations, coming in at 11.2 thousand. Moreover, housing starts also surprised to the upside, coming in at 206 thousand. Finally, the unemployment rate also surprised positively, coming in at 5.8%. USD/CAD has risen by 1.2% these past 3 weeks. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Real retail sales yearly growth came in significantly below expectations, coming in at -2.7%. Moreover, the SVME Purchasing Manager's Index also surprised to the downside, coming in at 57.4. Finally, the KOF leading Indicator also surprised negatively, coming in at 100.1. EUR/CHF has been flat in recent weeks. We continue to be bearish on the franc on a cyclical basis, given that inflationary forces in Switzerland remain too tepid for the SNB to hike policy rates. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data In Norway has been mixed: Both headline and core inflation underperformed expectations, coming in at 3.1% and 1.6% respectively. Moreover, manufacturing output also surprised to the downside, coming in at -0.3%. However, registered unemployment surprised positively, coming in at 79.7 thousand. USD/NOK has risen by 1.5%, as falling oil prices have weighed heavily on the krone. We are bullish on the krone relative to the Canadian dollar, given that rate expectations in Canada are much more fully priced in Canada than they are in Norway, even though the inflationary backdrop is similar. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.1%. Manufacturing PMI also outperformed expectations, coming in at 55. However, headline inflation surprised to the downside, coming in at 2.3%. USD/SEK has depreciated by roughly 1% for the past 3 weeks. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. With that being said, the krona could suffer if global growth slows further, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades