Economy
Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.
Highlights Federal Reserve: Is the U.S. neutral rate now higher? ECB: How much has the euro rally damaged European growth? Bank of Japan: Will a stronger yen tip Japan back into deflation? Bank of England: Will higher real wages offset Brexit uncertainties? Bank of Canada & Reserve Bank Of Australia: How much spare capacity truly exists? Feature We have not published a regular Weekly Report in Global Fixed Income Strategy since February 6th. We instead published necessary Special Reports on two countries of immediate relevance: Japan, because of the recent surprising strength in the yen, and Italy, because of the upcoming election. The pause in our regular commentary on the state of the markets, however, was useful. It has given us more time to reflect on the potential for a continuation of the global bond bear market after the volatility spike earlier in the month. What we find interesting is that, despite the common narrative that the back-up in global bond yields seen in 2018 has been about rising inflation fears, market pricing suggests the big shift has instead been in real bond yields and central bank policy expectations. In Table 1, we present the year-to-date change in the 10-year government bond yield for the major developed markets. We also show the changes in various other interest rate measures, including: Table 12018 Year-To-Date Changes In Government Bond Yield Components Our 12-month Policy Rate Discounters, which show the change in short-term interest rates priced into money market curves Our proxy measure of the market pricing of the real neutral ("terminal") interest rate - the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward Our estimate of the term premium on the 10-year government bond yield. What stands out in the table is that markets have moved to price in both a higher amount of expected rate hikes over the next year (Chart 1) and a higher neutral real interest rate, even with very little change in expected inflation. This can also been seen by looking at recent declines in the correlations between inflation expectations and nominal bond yields in the major economies, which are off from the peaks seen late in 2017 (Chart 2). Chart 1Rising Rate Expectations Have##BR##Been Pushing Yields Higher Of Late... Chart 2...Rather Than Higher##BR##Inflation Expectations The obvious conclusion is that the bulk of the rise in global bond yields seen year-to-date has been driven by increases in the real yield component, which itself has been heavily influenced by expected changes to central bank policy rates. Keeping that in mind, in this Weekly Report, we take a look at the most important question faced by each major central bank, and what that means for future decisions on policy interest rates - and by extension, for government bond yields. The Federal Reserve: "Is The U.S. Neutral Rate Now Higher?" With the 10-year U.S. Treasury yield having taken several runs at the critical 3% level in recent weeks, the debate has raged among investors as to whether that should be considered a breakout point or a buying opportunity. Comparing the U.S. economy now to what it looked like the last time the 10-year yield was at 3% at the end of 2013 suggests that yields could have more upside: Real GDP growth: 1.7% then, 2.3% now1 The unemployment rate: 6.7% then, 4.1% now Headline CPI inflation: 1.4% then, 2.1% now Core CPI inflation: 1.7% then, 1.8% now Average Hourly Earnings growth: 1.9% then, 2.9% now Growth is faster, there is less spare capacity, and inflation is higher now than it was just over four years ago. Yet when looking at the decomposition of the 10-year U.S. Treasury yield into its real and inflation expectations component (Chart 3, 2nd panel), we find that the mix is only slightly more skewed to real yields today: Chart 3Treasury Yields Still Have More Upside,##BR##Based On 2013 Comparisons Nominal 10-year Treasury yield: 3.03% then (December 31st, 2013), 2.87% now (February 26th, 2018) Inflation expectations (10-year CPI swap): 2.54% then, 2.30% now Real yields (nominal 10-year yield minus 10-year CPI swap): 0.49% then, 0.57% now In other words, the real yield today is 20% of the total nominal 10-year yield compared to 16% back at the end of 2013. Not a major difference. Yet there are much bigger discrepancies between the elements that go into our real neutral rate proxy for the U.S. (bottom two panels): 5-year OIS rate, 5-years forward: 4.1% then, 2.6% now 5-year CPI swap rate, 5-years forward: 2.9% then, 2.3% now Real neutral rate proxy: 1.2% then, 0.3% now The market is now pricing in a real neutral funds rate that is nearly one full percentage point below the level that prevailed the last time the 10-year Treasury yield reached 3% prior to 2018. Even though the U.S. economy is now growing faster, with far less spare capacity and higher inflation, than it did at the end of 2013. This does suggest that the level of the neutral real fed funds rate has likely gone up, which the 43bps increase in our market-implied real neutral rate proxy so far in 2018 is likely reflecting. But does the Fed actually believe that the neutral funds rate should be higher? The minutes from the January FOMC meeting, released last week, noted that there was discussion on the neutral funds rate, but one that was different than during previous FOMC meetings in 2017 - the actual appropriate level of the neutral funds rate was a topic of debate: "Some participants also commented on the likely evolution of the neutral federal funds rate. [...] the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets."2 Any change in the Fed's estimation of the long-run neutral funds rate is critical for the future path of Treasury yields, given where market pricing is at the moment. The U.S. OIS curve has now fully converged to the FOMC interest rate projections (the "dots") for this year and next year. More importantly, the market-implied terminal rate (the nominal 5-year OIS rate, 5-years forward) has now caught up to the FOMC terminal rate dot (Chart 4). The implication is that any further meaningful increase in Treasury yields can only come from higher inflation expectations - unless the Fed signals that a higher neutral rate is required. Our colleagues at our sister publication, U.S. Bond Strategy, recently noted that the Fed has historically been much more reluctant to raise its terminal rate projection in response to rising inflation than it was in cutting the projection when inflation falls.3 The conclusion is that inflation expectations will likely need to return to levels consistent with the Fed's inflation target - 2.3-2.5% on both the 10-year TIPS breakeven rate and the 5-year breakeven rate, 5-years forward - before the Fed would make any significant upward revisions to its terminal rate projection. In the meantime, Treasury yields are more likely to see a near-term consolidation, as U.S. data surprises have rolled over, market positioning has become very short, momentum is oversold and market pricing has fully converged with Fed expectations (Chart 5). In terms of data, the release of the next U.S. Employment report on March 9th is critical for the Treasury market in the near term, given that the January uptick in wage growth was the trigger for the spike in bond yields, and subsequent equity market correction, at the beginning of February (bottom panel). Chart 4Could The Fed Move##BR##The Interest Rate 'Goalposts'? Chart 5Treasury Selloff May Be##BR##Due For A Pause The ECB: "How Much Has The Euro Rally Damaged European Growth?" The European Central Bank (ECB) has been slowly preparing markets for an eventual withdrawal of its extraordinary monetary policy stimulus since last summer. Specifically, the ECB has begun a discussion of what it would take to end its bond buying program. Already, the central bank cut the monthly pace of its asset purchases in half at the beginning of 2018, and the topic of "tapering" has come up in many speeches from ECB officials. The ECB has been trying to not present an overly hawkish message when discussing an eventual end to its hyper-easy monetary stance. The overall level of government bond yields - both in the core and Periphery of the Euro Area - has been drifting higher, but by less than the increases seen in the U.S. Inflation expectations have been rising since the middle of 2017, although most of the 23bps increase in the benchmark 10-year German Bund yield seen so far in 2018 can be attributed to rising real yields (Chart 6). The market-implied real neutral rate has also been increasing, but still remains below zero (-0.2%). Yet despite only the modest increase in European interest rate expectations, there has been a substantially larger move in the euro. The trade-weighted euro has bond up by 8% over the past year, bringing the currency back to levels last seen in 2014 (Chart 7, top panel). The appreciating euro has become a subject of focus by the ECB, although it is not yet a cause for worry according to the minutes of the January ECB meeting released last week: Chart 6Only A Modest Rise In European Yields, So Far Chart 7A Potential ECB Dilemma "[...] although the past appreciation of the euro had so far had no significant impact on euro area external demand, volatility in foreign exchange markets represented a further increase that need monitoring."4 Chart 8No Damage Yet To European##BR##Exports From The Euro Rally The ECB is correct that the rising euro has not yet impacted Euro Area exports, the growth rate of which remains solid at 8% (bottom panel). This contrasts sharply with the performance the last time the trade-weighted euro was at current levels in 2014, when exports were barely growing at all. The difference is a much stronger global economy that is demanding far more European goods and services now compared to four years ago. For now, the ECB can look to the stability of export demand as a sign that the euro has not become a drag on the economy, but some warning signals may be flashing. Euro Area economic data surprises have plunged sharply, and the manufacturing PMI data has been softer in the past couple of months (Chart 8). While the absolute levels of the PMIs suggest an economy that is still growing at an above-trend pace, a continuation of the recent drops could pose a problem for the ECB as it tries to communicate its next policy move to the markets. The surging euro has done very little to drag down overall Euro Area headline inflation, given the strength in global oil prices over the past year (3rd panel). Core inflation has struggled to stay much above 1% over the past year or so, but our core inflation diffusion index - which measures the number of core Euro Area HICP sectors with rising inflation rates versus those with falling inflation rates - has surged in the past couple of months, which typically leads to a faster rate of core inflation (bottom panel). As long as the Euro Area export growth data holds up, the ECB is likely to focus more on rising core inflation than a stronger euro and should begin signaling an end to the asset purchase program by year-end. The Bank Of England: "Will Faster Wage Growth Offset Brexit Uncertainty?" The Bank of England (BoE) has surprised markets with its more hawkish commentary of late, particularly given the reason for the change - faster wage growth. The BoE had previously been cautious on its outlook for the U.K. economy, which was suffering from two powerful drags. First, the uncertainty over the Brexit negotiations was dampening business confidence and restraining capital spending. Second, the surge in realized inflation following the post-Brexit collapse of the British Pound triggered a period of contracting real wages that would be a drag on consumer spending. Until these were resolved, the BoE would be cautious with its future policy moves. Next month's European Union (EU) summit can provide some news on Brexit, as the U.K. government will be seeking a transition agreement that would give U.K. businesses a firm timeline for the separation of the U.K. from the EU. The U.K. government is reported to be seeking a two-year period for the agreement, but it may take longer than that to hammer out all the deals involved with the contentious issues of trade, immigration, etc. The longer the Brexit transition period, the more likely that U.K. firms will hold back on long-term investment spending because of uncertainty. As for the wage side of the story, the annual growth rate of Average Weekly Earnings has increased from 1.7% to 2.6% since the April 2017 low, but this is still below the headline CPI inflation rate of 3% (Chart 9, bottom panel). With the U.K. unemployment rate at a cyclical low of 4.4% - far below the OECD's estimate of the full employment NAIRU rate of 5.1% - additional increases in wage growth are possible if hiring demand does not begin to slow. Yet with U.K. data surprises rolling over (top panel), and with the OECD's U.K. leading economic indicator decelerating (middle panel), there is a growing risk that economic growth will slow in the coming quarters, to the detriment of hiring activity and wages. The current market pricing shows that there remains a wide gap between U.K. inflation expectations and nominal Gilt yields (Chart 10). The real 10-year Gilt yield is -1.84% (deflated by CPI swaps), while the market-implied neutral real interest rate is -1.94%. While such a deeply negative interest rate is unlikely to be a permanent state of affairs in the U.K., such an accommodative policy setting is required to prevent the economy from falling into a deep slump. Chart 9Is The BoE More Worried About##BR##Wage Pressures Than Growth? Chart 10Real Gilt Yields Rising,##BR##But Still Very Low As we noted back in January, we do not see the BoE being able to raise rates much at all this year given the likelihood of prolonged sluggishness of the U.K. economy and some reversal of the currency-fueled surge in inflation seen in 2017.5 The BoE choosing to tackle rising wage inflation while growth was decelerating would be a huge policy error that would eventually benefit the performance of U.K. Gilts. The Bank Of Japan: "Will A Stronger Yen Tip Japan Back Into Deflation?" The extraordinary monetary policy accommodation provided by the Bank of Japan (BoJ) makes an analysis of Japanese Government Bond (JGB) yields far less interesting. After all, when the central bank is actively intervening in large quantities to hold the level of the 10-year JGB around 0%, do the signals sent from money market and bond yield curves have any meaning vis-à-vis the actual Japanese economy? Right now, the pricing of the real 10-year JGB yield (deflated by CPI swaps) is just below 0%, as is the real terminal rate proxy from the Japanese OIS curve (Chart 11). Keeping JGB yields at such low levels is part of the BoJ's attempt to raise Japanese inflation back towards the central bank's 2% yield target. The mechanism by which that should happen is through a weaker Japanese yen. Yet the yen has been showing surprising strength in recent weeks, most notably the USD/JPY exchange rate that has been falling in the face of rising U.S.-Japan interest rate differentials (Chart 12, top panel). Chart 11Negative Real Rates Still Necessary In Japan Chart 12An Unwelcome Rise In The Yen The risk going forward is that the strengthening yen will create a drag on headline Japanese inflation that has recently accelerated back to 1% (middle panel). Given that both core CPI and nominal wages barely growing at all (bottom panel), the odds are increasing that Japanese inflation could begin to move lower without getting anywhere close to the BoJ's 2% target. As we discussed in our recent Special Report, a much weaker yen (i.e. USD/JPY between 115 and 120) is the first necessary precondition before the BoJ would consider raising its yield target on the 10-year JGB.6 We had placed odds of no more than 20% that the BoJ would raise its yield target in 2018, but if the yen continues to hold firm or even strengthen further from current levels, those odds fall to zero. Bank Of Canada & Reserve Bank Of Australia: "How Much Spare Capacity Truly Exists?" We are lumping the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) together in this report, as both are facing the same critical question. The BoC has already raised its policy rate three times since last summer, in response to accelerating growth and diminished spare capacity in Canada. Canadian bond yields have risen in response through higher inflation expectations, rising real yields and greater expected rate increases from the BoC (Chart 13). The real 10-year Canadian yield has risen back to the highs last seen in late 2013, while inflation expectations are not quite back to those levels - a similar story to that seen in the U.S. The BoC's own estimate of the Canadian output gap flipped into positive territory at the end of 2017, signifying that there was no longer any spare capacity in the Canadian economy (Chart 14, top panel). The signal from the Canadian labor market is similar, with the unemployment rate now at 5.9% - well below the OECD NAIRU estimate of 6.5% (middle panel). Yet Canadian inflation rates, both for headline and core CPI, are only at 1.7% and 1.5%, respectively - both not even at the midpoint of the BoC's 1-3% target band (bottom panel). At the same time, wages have been accelerating, with the annual growth rate of Average Hourly Earnings now up to a two-year high of 3.3%. Chart 13All Bond Yield Components Rising In Canada Chart 14Where's The Inflation? Such a wide gap between price inflation and wage growth does throw into the question if the BoC's own output gap estimate is correct. We expect Canadian price inflation to eventually begin to close the gap with wage inflation, which will keep the BoC on its current expected rate hiking path in 2018 as long as the economy does not begin to slow meaningfully. The CPI inflation reports will be the most important data to watch in Canada over the next few months to determine if our view will pan out. In Australia, the market pricing is nowhere near as hawkish as in Canada, with inflation expectations (10-year CPI swaps) having been stuck in a range between 2.2-2.4% for the past two years (Chart 15, 2nd panel). The market-implied neutral real interest rate is stuck at 0% and has not been sustainably above that level since 2014 (bottom panel). Yet, like Canada, there are questions about the true degree of slack in the economy. The Australian unemployment rate is currently at 5.5%, well below NAIRU (Chart 16, top panel). The last time that the Australian economy ran for so long beyond full employment was in 2010-11, when headline inflation breached the upper limit of the RBA's 1-3% target band (bottom panel). Yet the so-called "underemployment rate" - essentially, those working part-time that would like to work full-time - has been much higher in recent years and now sits at 8.3%. This also fits with the IMF's estimate of the Australian output gap, which is still a very large -1.8%. Chart 15Australian Yields Are Stuck In A Range Chart 16Very Different Than 2011-12 Given these signs of excess capacity in both the labor market and the overall economy, it is no surprise that Australian inflation has struggled to surpass even the 2% midpoint of the RBA target band. The implication is that the Australian NAIRU is much lower than the official OECD estimate, and that the RBA is under no pressure to contemplate any interest rate increases for at least the rest of 2018. Net-net, while both the BoC and RBA are facing questions over the true amount of spare capacity in their economies, the situation is much more bullish for Australian government bonds than Canadian equivalents given the greater slack Down Under. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 These are average quarterly growth rates of U.S. real GDP for the full calendar year of 2013 and 2017, respectively. 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180131.pdf 3 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20th, 2018, available at usbs.bcaresearch.com. 4 https://www.ecb.europa.eu/press/accounts/2018/html/ecb.mg180222.en.html 5 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt Up In Equities AND Bond Yields?", dated January 23rd, 2018, available at gfis.bcaresearch.com. 6 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.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 We are shifting our U.S. recession call from late-2019 to 2020. A cheap dollar and fiscal support will give the Fed more scope to raise rates before monetary policy moves into restrictive territory. The fiscal impulse will fall sharply in 2020. By then, financial conditions will be tighter and economic imbalances will be more pronounced. As is usually the case, a downturn in the U.S. will infect the rest of the world. Emerging markets with large current account deficits and high debt levels are most vulnerable. A cyclical overweight to global equities is still appropriate, but long-term investors should begin to scale back risk exposure. Feature Records Are Meant To Be Broken The NBER Business Cycle Dating Committee, which contrary to popular belief does not serve as a matchmaking service for lonely-heart economists, estimates that the current economic expansion is going on nine years. If it makes it to July 2019, it will be the longest in history (Chart 1). Considering that records begin in 1854 - encompassing 33 business cycles - that will be an impressive achievement. Chart 1Nine Years And Still Going Strong There is an old adage that says "Expansions do not die of old age. They are murdered by the Fed." A year or so ago, it looked like the Fed would pull the trigger sometime in 2019. Now, however, it looks more likely that the deed will be committed in 2020. Two things have changed since the start of last year. First, the real trade-weighted dollar has fallen by 8%. According to the Fed's SIGMA macroeconomic model, this should boost growth by about 0.3% over the next two years. Chart 2U.S. Fiscal Policy Has Become##BR##Much More Stimulative Second, U.S. fiscal policy has become much more stimulative, a point very much in keeping with our Geopolitical Strategy team's long-standing view that age of austerity is giving way to a new age of populism.1 My colleague Mark McClellan estimates that the U.S. fiscal impulse will reach 0.8% of GDP in 2018 and 1.3% of GDP in 2019, up from -0.4% and 0.3%, respectively, in the IMF's October 2017 projections (Chart 2). Mark's calculations incorporate the CBO's assessment of the tax cuts, the recent Senate deal to raise the caps on defense and nondefense expenditures, and $45 billion in hurricane relief. He assumes some delay between when the bill is passed and when the spending takes place. According to the Congressional Budget Office, a little more than half of the expenditures in the 2013 and 2015 spending bills occurred in the same year the funding was authorized. These fiscal measures will cause the federal budget deficit to swell by about 2.3 percentage points to 5.6% of GDP in FY2019. Even that may be an understatement, as this does not include any additional infrastructure spending nor the possible restoration of "earmarks"- the widely criticized practice that allows members of Congress to add appropriations to unrelated bills to fund what often turn out to be politically motivated projects in their districts - which could add a further $25 billion in annual spending. Meanwhile, federal government revenue is coming in below target, which the Office of Management and Budget (OMB) has attributed to lower-than-expected taxable income from pass-through businesses and capital gains realizations. This problem could worsen over the next few years as creative accountants find new loopholes to exploit in the recently passed tax bill. Too Much, Too Late All this stimulus is arriving when the economy least needs it. The unemployment rate currently stands at 4.1%, 0.5 points below the level the Fed regards as consistent with full employment. It has been stuck at that number for four straight months, largely because job growth in the Household survey (which the unemployment rate is based on) has lagged the Establishment survey by a considerable margin. Given the underlying strength in GDP growth, it is likely the job gains in the Household survey will rebound strongly over the course of 2018, taking the unemployment rate down to 3.5% by year-end, well below the Fed's end-2018 projection of 3.9%. A lower-than-projected unemployment rate will permit the Fed to raise rates four times this year, one more hike than currently implied by the dots. The Fed will probably also hike rates three or four times next year. Yet, even those additional rate hikes will not come close to offsetting all the fiscal stimulus coming down the pike. In the absence of a sustained increase in productivity or labor force growth - neither of which appear forthcoming - the economy will continue to overheat. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). The Fed knows this perfectly well, but has chosen to let the economy run hot for fear that a premature tightening will sow the seeds for a deflationary spiral. Chart 3Inflation Is A Lagging Indicator By the time the next recession rolls around, inflation will be higher and financial and economic imbalances will be greater. The fiscal impulse will also fall back towards zero in 2020 as the budget deficit stabilizes at an elevated level. It is the change in the budget balance that is correlated with GDP growth. If output is already being constrained by a lack of spare capacity going into late-2019, the subsequent decline in the fiscal impulse in 2020 could push growth below trend, leading to rising unemployment. And, as we have often noted, once unemployment starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point that was not associated with a recession (Chart 4). Chart 4Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle A recent IMF report highlighted that changes in U.S. financial conditions strongly influence growth abroad.2 As the U.S. falls into a recession, equity prices will tumble and credit spreads will widen. Financial conditions will tighten, transmitting the downturn to the rest of the world. Emerging markets with large current account deficits and high debt levels will be the most vulnerable. The only saving grace is that interest rates will be higher in 2020 than they would have been if the recession had begun in 2019. This will give the Fed a bit more scope to ease monetary policy again. As discussed last week, this will likely set the stage for a stagflationary episode following the recession.3 For Now, Leading Indicators Look A-Okay While our baseline view is that the next recession will occur in 2020, this is more of an educated guess than a firm prediction. Many things, including an overly aggressive Fed, a sharp appreciation in the dollar, and a variety of political shocks, could cause the recession to occur sooner than anticipated. As such, we continue to watch a wide swathe of data to help guide our investment recommendations. The good news is that right now, none of our favorite leading economic indicators such as the level of ISM manufacturing new orders minus inventories, capital goods orders, initial unemployment claims, and building permits are flashing red (Chart 5). Many of these indicators appear in The Conference Board's LEI, which is still rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator (Chart 6). We are still far from that point. Chart 5U.S. Leading Indicators Looking A-OKAY Chart 6U.S. LEI Is Not Flashing Red The same goes for leading financial variables such as credit spreads and the yield curve. The yield curve has inverted in the lead-up to every recession over the past 50 years (Chart 7). The fact that the 10-year/3-month slope has steepened by 30 basis points since the start of the year gives us some comfort that the next recession is still some time away. Chart 7An Inverted Yield Curve Has Often Been A Harbinger Of A Recession Keep An Eye On Credit Credit spreads remained well contained during the recent bout of market turbulence but we continue to watch them closely. Credit typically starts to underperform before equities do, which makes it a good leading indicator for the stock market. This is likely to be especially the case over the next two years. If there is one area where financial imbalances have accumulated to worrying levels, it is in the corporate debt arena. This month's issue of the Bank Credit Analyst estimates that the interest coverage ratio for U.S. companies would drop from 4 to 2½ if interest rates were to increase by 100 basis points across the corporate curve.4 This would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 8). Consumer staples, tech, and health care would be the most affected. Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (I) Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (II) We currently maintain an overweight to equities and spread product but expect to move to neutral later this year and to underweight sometime in 2019. Long-term investors should consider paring back exposure to both asset classes already, given that valuations have become stretched. The Dollar And The Return Of "Twin Deficits" Bigger budget deficits will drain national savings. Since the current account balance is simply the difference between what a country saves and what it invests, the U.S. current account deficit is likely to increase. How the emergence of these twin deficits will affect the dollar is a tough call. Historically, there is no clear relationship between the sum of the fiscal and current account balance and the value of the trade-weighted dollar (Chart 9). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a decline in the household saving rate from the booming housing market. Much depends on what happens to real interest rates. If investors come to believe that persistently large budget deficits will lead to higher inflation, long-term real yields could decline, pushing the dollar lower. In contrast, if investors conclude that the Fed will raise rates by enough to keep inflation from spiraling upwards, real yields could rise. U.S. real yields have gone up across all maturities since the start of the year. As a result, real rate differentials have widened between the U.S. and its developed market peers (Chart 10). However, some of the increase in U.S. real rates has been due to a rising term premium, with the rest reflecting an upward revision to the expected path of policy rates. The latter is good for the dollar. The former is not, because it means that investors are starting to worry about the ability of the market to absorb the increasing supply of Treasurys. Meanwhile, rising interest rates threaten to put further pressure on the U.S. current account deficit. The U.S. net international investment position has deteriorated from -10% of GDP to -40% of GDP since 2007 (Chart 11). The U.S. owes the rest of the world about 68% of GDP in debt - almost all of which is denominated in dollars - but holds only 23% of GDP in foreign debt. Thus, a synchronized increase in global bond yields would cause U.S. net interest payments to rise. If yields in the U.S. increase more than elsewhere, net payments would rise even more. Chart 9Twin Deficits And The Dollar:##BR##No Clear-Cut Relationship Chart 10Real Rate Differentials Have##BR##Widened Between The U.S. And Its DM Peers Chart 11Deterioration In U.S. Net##BR##International Investment Position America's status as a major net external debtor could also constrain the extent to which the dollar appreciates. If the greenback were to strengthen, the dollar value of U.S. external assets would decline, as would the dollar value of interest or dividend payments that the U.S. receives from abroad. This would result in a deterioration in the current account balance and in a worsening in the U.S. net international investment position. Some Positives For The Greenback While the discussion above is bearish for the dollar, it needs to be put into some context. The U.S. current account deficit stands at 2.3% of GDP, down from almost 6% of GDP in 2006 (Chart 12). Much of the improvement in the U.S. balance of payments can be traced back to the plunge of almost 70% in net oil imports, a development that is likely to be permanent given the shale boom. Furthermore, the U.S. trade balance should benefit over the coming quarters from the lagged effects of a weaker dollar. And while we estimate that the primary income balance will deteriorate by about 0.6% of GDP over the next two years, it should still remain in positive territory and above the levels from a decade ago (Chart 13). Chart 12U.S. Balance Of Payments:##BR##Improvement Due To Sinking Oil Imports Chart 13Primary Income Balance Will Decline,##BR##But Will Remain In Positive Territory On the fiscal side, the projected rise in U.S. government debt levels at a time when the economy is booming is concerning. Nevertheless, the U.S. debt profile still compares favorably to countries such as Japan and Italy, two economies with worse growth prospects than the U.S. Italian 30-year bond yields are actually lower than in the United States. If one of the two countries is going to have a debt crisis over the next decade, our guess is that it will be Italy and not the U.S. A Cresting In Global Growth Could Help The Dollar Our preferred explanation for why the dollar began to weaken in 2017 focuses on the role of global growth as well as on technical factors. Chart 14USD Is A Momentum Winner Strong global growth - especially when concentrated outside the U.S., as was the case last year - tends to hurt the dollar. There are a number of reasons for this. First, a robust global economy pushes up natural resource prices, which boosts the terms of trade for commodity-exporting economies. Second, manufacturing represents a smaller share of the U.S. economy than it does in most other countries. Since manufacturing activity is quite cyclically-sensitive, faster global growth benefits economies such as Germany, Sweden, Japan, China, and Korea more than the U.S. Third, stronger global growth tends to boost risk appetites. This has translated into large inflows into EM funds and peripheral European debt markets. The latter have also seen an ebbing of political risk, which has translated into sharply lower sovereign spreads. The acceleration in global growth came at a time when long dollar positions had reached elevated levels. As those positions were unwound, the dollar began to tumble. At that point, the strong upward momentum that fueled the dollar rally following the U.S. presidential election was replaced by downward momentum. The U.S. dollar is one of the most momentum-driven currencies out there (Chart 14). Weakness led to even more weakness. It is impossible to know when the dollar's downward momentum will exhaust itself. What can be said is that speculative positioning has become increasingly dollar bearish. This raises the odds of a short-covering dollar rally (Chart 15). Chart 15Speculative Positioning Has Gotten Increasingly Dollar Bearish Perhaps more importantly, global growth may be peaking. China's economy has slowed, as gauged by the Li Keqiang index, which combines electricity production, freight traffic, and bank lending (Chart 16). Growth in Europe and Japan has also likely reached top velocity. U.S. financial conditions have eased sharply relative to the rest of the world (Chart 17). This, in conjunction with an easier U.S. fiscal policy, suggests that the composition of global growth will shift back towards the U.S. over the coming months. If this were to happen, the dollar could recoup some its losses. Chart 16Chinese Economy##BR##Has Slowed Chart 17U.S. Financial Conditions Have##BR##Eased Sharply Relative To ROW Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016. 2 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, April 2017. 3 Please see Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. Available at bca.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The combined U.S. current account and fiscal deficits are set to rise as Trump's profligacy and higher interest rates kick in. In and of itself, this does not spell doom for the dollar. The Fed's response to the twin deficit is what will ultimately set the path for the greenback. Stimulus hitting an economy at full employment raises the likelihood that the Fed will not stand idly by. The dollar's momentum is not deteriorating anymore, global growth could hit a soft patch, and U.S. hedged yields might regain some composure versus European hedged yields. These factors are likely to precipitate a dollar rebound. The durability of this rebound remains an unknown. An opportunity to go short EUR/SEK has emerged. Feature When it comes to the U.S. dollar, the story of the day has become the twin deficits. It is now presented as the key factor that will drag the dollar lower over the course of the cycle. We do agree there are plenty of reasons to be concerned with the long-term outlook for the dollar. However, we remain unconvinced whether the twin deficits really are the much-vaunted "boogey man" that will haunt the greenback. In fact, we would argue that while they are a handicap for the dollar, the role of the Federal Reserve, global growth and hedging costs take precedence over the evil twins. The Twin Deficit Will Widen We take no offence with the assertion that the twin deficits are set to increase. According to the work of Mark McClellan, who writes The Bank Credit Analyst, the U.S. fiscal deficit is set to increase to 5.5% of GDP over the course of the next two years. U.S. President Donald Trump's tax cuts and the recent spending agreement will undeniably contribute to this.1 The current account deficit is also set to widen. Chart I-1 shows our estimate for the path of the current account. We anticipate it to move to -3.4% of GDP by late 2018 or early 2019. This is a noteworthy deterioration, but one that only brings the U.S. current account to a level last experienced in 2009. One contributor is obviously the trade balance. The Bank Credit Analyst estimates that the impact of the combined fiscal measures announced will reach 0.3% of GDP in 2018. The biggest source of deterioration will not come from trade: it will come from a fall in the net primary income balance of the U.S., which currently stands at 1.1% of GDP. Essentially, higher interest rates in the U.S. means that foreigners will receive greater income from the U.S. Based on the current level of the median long-term interest rate forecasts by the FOMC's participants, my colleague Ryan Swift estimates that a move in 10-year Treasury yields to 3.5% is likely by year end.2 Based on our estimate, this will push down the primary income balance to 0.4% of GDP. It is important to acknowledge that this forecast for the current account is likely to prove to be a worst-case scenario. To begin with, the trade balance could continue to be buffeted by the fact that U.S. energy production keeps expanding, which is slowly but surely moving the U.S. toward a positive energy trade balance (Chart I-2). Moreover, periods of weakness in the USD have been followed by improvements in the U.S. primary income balance. This is because while payments made by the U.S. to foreigners are mostly in the form of interest, 55% of U.S. income receipts are earnings on FDIs. If we add dividends received on foreign equity holdings, this share rises to 80% of U.S. gross primary income. Thus, if the dollar weakens, U.S. receipts benefit from a translation effect as corporations convert their foreign earnings back into U.S. dollars at more beneficial exchange rates. Chart I-1Higher U.S. Rates ##br##Will Hurt The Current Account Chart I-2U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance But do twin deficits even matter? We would argue, it depends. Bottom Line: The U.S. twin deficits are set to increase. The U.S. fiscal deficit will move to 5.5% of GDP and the current account to -3.4% of GDP as interest owed to foreigners is set to increase. Twin Deficit, So What? It is one thing to anticipate a widening of the twin deficits, but does history suggest that twin deficits have an impact on the dollar? Here, the empirical evidence is rather mixed. As Chart I-3 illustrates, there has been no obvious link between twin deficits and the dollar. In fact, Arthur Budaghyan highlighted in BCA's Emerging Market Strategy service the following phases:3 1970s: no discernable relationship; First half of the 1980s: Substantial widening of twin deficits, but a massive dollar bull market materialized; 1985 to 1993: no reliable relationship between twin deficits and the dollar; 1994 to 2001: The dollar did rally as twin deficits narrowed on the back of the fiscal balance moving from roughly -4% of GDP to 2% of GDP; 2001 to 2011: dollar weakened as twin deficits grew deeper; 2011 to 2016: When twin deficits narrowed considerably, the dollar was stable, but when they stopped improving, the dollar rallied 25%. Chart I-3In My Time Of Dying? Let us focus on the growing twin deficits episodes. As it turns out, the missing link between twin deficits and the dollar is Fed policy. A widening in twin deficits is normally associated with a strong economy. Profligate government spending can boost domestic demand, and because imports have a high elasticity to domestic demand, a widening current account also tends to come alongside robust growth. The Volcker Fed played a high-wire act from 1979 to 1982, plunging the U.S. into a vicious double-dip recession in order to bring realized and expected inflation back to earth after the 1970s. Volcker was not about to let former President Ronald Reagan's stimulus boost growth to the point of lifting inflation expectations again, undoing all the Fed's previous good work. He elected to increase real rates sharply, which was the key factor behind the dollar's strength. The 2001 to 2011 experience needs to be broken down in parts. From 2001 to 2003, the twin deficits were expanding thanks to former President George Bush's wars and tax cuts. Yet the Fed did not play the same counterweight as it did in the mid-1980s. Instead, it kept cutting rates all the way until 2003 as then-Chairman Alan Greenspan was worried about deflation. U.S. real rates did not experience the necessary lift required to fight the negative impact of the twin deficits on the dollar. From 2003 to 2007, the twin deficits were in fact narrowing, real rates were trendless and the dollar was experiencing mild depreciation. During that time frame, global growth was extremely robust, China was growing at a double-digit pace and EM economies were booming. Money was flowing toward these destinations. From 2007 to mid-2008, while the twin deficits continued to narrow, the dollar plunged. The sharp fall in real rates as the Fed engaged in aggressive rate cutting explains this apparent inconsistency. From the second half of 2008 to 2009, the dollar surged, despite a further widening of the twin deficits. Real rates rebounded as inflation expectations melted, and risk aversion prompted investors to seek the safety of the global reserve asset and the global reserve currency - Treasurys and the greenback, respectively. From 2009 to the middle of 2011, the twin deficits stabilized, real rates stabilized, and the dollar stabilized as well, but nonetheless experienced wild gyrations as the global economy kept experiencing aftershocks from the great financial crisis. Neither the twin deficits nor real rates were offering a clear path forward, thus the dollar was also mixed. Bottom Line: A close look at various episodes of twin deficits in the U.S. pushes us toward one conclusion: if twin deficits are expanding but the Fed is trying to tighten policy and real rates are rising, the dollar ignores the twin deficits and, in fact, manages to rise. If, however, the twin deficits expand, and real rates do not experience enough upside to counterbalance this development, the dollar weakens. This means one thing for the coming years: Forecasting twin deficits is not sufficient to predict a dollar bear market. Instead, we also need a view on the Fed and the outlook for real rates. So Where Will The Dollar Go In 2018? We expect there could be some upward pressure on the Fed's dots as the year progresses. The reason is rather straightforward. The U.S. economy will receive a very large shot in the arm this year and next. Mark's calculations show that the fiscal thrust in 2018 and 2019 will morph from -0.4% of GDP to 0.8% of GDP, and from 0.3% of GDP to 1.3% of GDP, respectively (Chart I-4). While currently the fiscal thrust is expected to become a large negative in 2020, that year is an election year. There is a non-trivial probability that the fiscal cliff anticipated that year may in fact be postponed: it is not in the interest of the Republicans or Democrats to be blamed for a slowing economy in a year where Americans are hitting the voting booths! This stimulus is not happening in a vacuum either: it is materializing in an environment where the labor market seems to be at full employment, where capacity utilization is tight, and where financial conditions remain easy (Chart I-5). Stimulating when the economy is at full capacity is likely to lift prices more than it will boost real economic activity. The Fed is fully aware of this risk. Chart I-4Much Stimulus ##br##In The Pipeline Chart I-5Could Fiscal Stimulus Be Inflationary With This Backdrop?##br## We Think So However, it remains possible that the Fed will err on the side of caution and wait until the impact of the stimulus measures on the economy become more evident before sending a more hawkish message to the markets. Chart I-6Twin Deficits Narratives ##br##Look Like Ex-Post Explanations If the Fed elects to be proactive and adjusts its message regarding the future path of policy before the impact of the stimulus becomes evident, the dollar could rise as it would put upward pressure on U.S. real rates. If, however, the Fed elects to be reactive and wait until the economy responds to the stimulus package with higher wage growth and inflation, then the dollar could weaken as real rates experience little upside and the twin deficits exact their toll. BCA is currently conducting research to assess which path is more likely. In the meanwhile, there other factors to consider. First, as we highlighted three weeks ago, since 2011, spikes in the number of mentions of the twin deficits in media have historically been associated with temporary rebounds in the dollar following periods of USD weakness (Chart I-6).4 The twin deficits seem to come to the forefront of investors' minds as an ex-post explanation for previous weak-dollar periods. Second, our dollar capitulation index is not only at oversold levels, but the indicator has formed a positive divergence with the trade-weighted dollar's exchange rate (Chart I-7). Technically, this increases the probability of a meaningful rebound in the USD. Chart I-7A Positive Technical Development For The Greenback Third, global growth is showing signs of weakening. We have already highlighted that rollovers in the performance of EM carry trades such as the one we have been experiencing for a few months now have been very reliable leading indicators of activity slowdowns over the past 20 years.5 Korea exports are also ebbing. As Chart I-8 illustrates, when Korean exports weaken, this tends to be associated with weakness in highly pro-cyclical financial variables like EM equities, EM bonds, AUD/USD or AUD/JPY. When a slowdown in global growth materializes, especially when it does so as the U.S. economy is set to accelerate, it tends to be associated with a stronger dollar. Fourth, the super-charged strength in the euro versus the USD since the second quarter of 2017 happened as European hedged yields overtook U.S. hedged yields. Chart I-9 takes the example of a Japan-based investor. We pick Japan as an illustration because Japan is the largest creditor nation in the world, and extra-low domestic yields, Japanese investors continue to exhibit heightened yield-seeking behaviors. When the gap between European bond yields hedged into yen and U.S. bond yields hedged into yen became more negative, the euro was depreciating. Once this gap started to narrow, the euro stabilized. Once European bond yields hedged into yen became greater than U.S. bond yields hedged into yen, the euro took off. Chart I-8Growth Sensitive Assets May Be At Risk Chart I-9Are Hedged Yields The Culprit Behind The Dollar's Weakness? We expect these gaps in hedged yields to move back in the U.S.'s favor. The U.S. yield curve has some scope to begin to steepen a bit, especially as U.S. growth accelerates. Additionally, a big component of the underperformance of U.S. hedged yields has been associated with a widening of the LIBOR spread and the cross-currency basis swap spreads (Chart I-10). As we anticipated, the introduction of tax rules favoring repatriations of foreign earnings by U.S. corporations is having this effect.6 U.S. firms hold their offshore earnings in high-quality securities like bank papers or Treasurys. These securities are a vital supply of dollars in the Eurodollar market - the offshore USD market - as they are high-quality collateral that can be used to secure many transactions. As the market in December began to discount the impact of the tax changes, FRA-OIS spreads and basis swap spreads began to widen. This increased the cost of hedging U.S. bonds. Chart I-10Will The Increase In Treasurys Issuance ##br##Pull Back Down The Cost Of Hedging U.S. Assets? But here's one overlooked but potentially friendly outcome of the twin deficits. By increasing its current account deficit, the U.S. economy will begin to supply more USDs to Eurodollar markets, providing a relief valve to the collateral-starved offshore USD-funding markets. Moreover, because the fiscal deficit is set to mushroom, and because after many debt-ceiling debacles the Treasury's cash reserves are low, the Treasury is likely to start issuing a lot more T-Notes and T-Bills, which will also provide a source of high-quality collaterals in the system, especially as the Fed is not buying those bonds anymore. The stress in the funding market may begin to recede and hedged U.S. yields may begin to rise relative to the rest of the world. Bottom Line: While the twin deficit could become a negative for the USD, it is not yet clear that this will indeed be the case. Instead, we need to keep in mind that the U.S. government is injecting a large amount of stimulus in an economy running at full capacity. This could be inflationary. The Fed's response will dictate the USD's path. If the Fed is proactive, the USD will experience an upswing. If the Fed is reactive and waits to guide real rates higher, the dollar could remain weak. In the meanwhile, other forces are pointing toward a rebound in the dollar. The greenback is oversold and unloved; momentum indicators are forming positive divergences, raising the odds of a rebound; global growth is set to slow; and U.S. hedged yields are likely to move back in favor of the dollar. Will EUR/SEK Break Above 10? The recent inflation miss in Sweden has raised some concerns, with EUR/SEK hovering around the critical 10 level, and NOK/SEK breaking above the 1.03 handle. Headline consumer prices rose only 1.6% annually in January, while contracting by 0.8% in monthly terms. The official inflation measure tracked by the Riksbank - the CPIF - fell to 1.7% per annum. This move away from the inflation target has market participants questioning the Riksbank's willingness and ability to normalize policy this year. However, the underlying picture is not that negative. The most recent inflation figure was greatly impacted by the seasonality of Swedish CPI. As Chart I-11 shows, January tends to be a very weak number for Swedish inflation. The February data is likely to rebound significantly. Additionally, our model further highlights that based on both international and domestic factors, Swedish inflation should rise in the coming months, putting CPI much closer to the Riksbank's objective (Chart I-12). Chart I-11Seasonal Pattern In Swedish CPI Chart I-12Swedish Inflation Is Set To Rebound Reassuringly, Swedish inflation expectations have not subsided, suggesting market participants are fading the latest weak reading. As the bottom panel of Chart I-13 illustrates, CPI swap rates are still holding steady. On the macro front, consumers continue to be a source of durable strength. Real consumption is growing at a 3% annual rate, and Swedish consumer confidence is still elevated (Chart I-14). Chart I-13Swedish Inflation Expectations Are Stable Chart I-14The Swedish Consumer Is Still Spending Essentially, the Riksbank's extremely easy monetary policy may not have yet generated inflation in the prices of consumer goods and services, but it has generated huge debt and asset price inflation. The clearest symptom of this is Sweden's non-financial private debt, which now stands at a stunning 240% of GDP, only surpassed by Switzerland and Norway among the G10 economies. These developments imply that the positive Swedish output gap will expand further, and that inflationary pressures will only become more entrenched. Thus, we continue to anticipate a rate hike by the Riksbank this year. This is very much a consensus call. However, where we diverge from consensus is that while futures are pricing in approximately 85 basis points of interest rate hikes by March 2020, we think the scope to lift rates is greater. We also see a higher probability of hikes over that time frame than the Riksbank's own forecast. In other words, we anticipate that the Riksbank's rate forecasts will be revised to the upside. This is because inflationary pressures are growing greater and the economy is very strong. Thus, the Swedish central bank is falling behind the curve and will have to play catch up as soon as inflation moves back closer to target. This will most likely happen over the coming 12 months. As a result, selling EUR/SEK at current levels seems an interesting trade with an attractive entry point. As Chart I-15 illustrates, EUR/SEK only traded above this level during the great financial crisis. It did not manage to punch above this level during the Nordic financial crises of the early 1990s, nor did it during the 1997-'98 crisis - or directly after the September 11 attacks. Chart I-15The Line In The Sand Moreover, EUR/SEK currently trades 7.5% above its purchasing power parity equilibrium. The gap between Sweden's and the euro area's basic balance of payments is very large. While Sweden's stands at 5.1% of GDP, the euro area's is near zero. This reinforces the message that the EUR/SEK is very expensive: when the cross appreciates too much, Swedish assets become much more attractive to foreigners relative to European assets. These long-term flows end up boosting the relative basis balance in favor of Sweden. This is exactly what is happening today (Chart I-16). Chart I-16Expensive EUR/SEK Makes Swedish Assets Attractive From a tactical perspective, EUR/SEK also looks vulnerable. Various short-term momentum measures such as the 14-day RSI or the 13-week rate of change are diverging from actual prices. Additionally, EUR/SEK risk reversals - i.e. the implied volatility of calls versus the implied volatility of puts on this cross - have spiked up. This is true even after controlling for the rise in implied volatility that has affected the option market. It seems to suggest that investors that would have been buying EUR/SEK have already placed their bets. The marginal player is likely to now bet in the other direction. This trade is not without risks. First, a move above 10.1 could be mechanically followed by a sharp rally as stops are hit and momentum traders force the cross higher. Second, Swedish PMIs have been rolling over for six months, but so have the preliminary releases of Europe PMIs this week. What is more concerning is the weakness in Asian manufacturing production that is behind the sharp slowdown in Korean exports. This is worrisome because historically, the Swedish economy has been very sensitive to EM shocks. However, only 2008 was able to push EUR/SEK above 10. Even if EM slows, we are not anticipating a shock as large as what occurred in 2015, let alone in 2008. Moreover, while we anticipate Swedish inflation to surprise to the upside, we equally expect euro area inflation to exhibit much more limited gains. Bottom Line: Sweden's inflation report came in well below expectations, which prompted a sharp rally in EUR/SEK to near 10. However, this level has been an important resistance since the early 1990s, only breached during the great financial crisis. We are betting on it not being breached this time around. The Swedish economy is strong, and inflation is set to pick up again. As a result, we think the Riksbank will be forced to lift its interest rate forecast as time passes. Moreover, EUR/SEK is expensive, and flows are currently very much in favor of Sweden. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, dated February 29, 2018, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "On the MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EM Local Bonds and U.S. Twin Deficits", dated February 21, 2018, available at ems.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot", dated February 2, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Weekly Reports, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and "Canaries In the Coal Mine Alert 2: More on EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Special Report, "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com. Currencies U.S. Dollar U.S. data was mixed: Markit PMIs beat expectations ; Existing home sales, however, grew by less than expected at 5.38 million, a 3.2% contraction form the previous month; Continuing jobless claims outperformed expectations, coming in at 1.875 million; Initial jobless claims also outperformed with 222,000. In the meeting's minutes, FOMC members were quite positive on growth and their rhetoric suggest they intend to follow up on the current set of dot plots. Subsequently, equities sold off, the 10-year yield climbed to 2.954%, bringing them close to BCA's fair value estimate. Due to these developments, the dollar's descent seems to be taking a breather for now, and it may even experience a rebound in the coming weeks. Chart II-1USD Technicals 1 Chart II-2 Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro The tone of European data has been deteriorating: German PMIs underperformed expectations, with services coming in at 55.3, and manufacturing, at 60.3; European PMIs also underperformed anticipations with manufacturing coming in at 58.5 and services at 56.7; The Current Situation section of the ZEW Survey was also weaker than expected; German IFO underperformed expectations, with the Business Climate measure coming in at 115.4, and the Expectations measure also dropping to 105.4. The euro weakened substantially this week on poor data and a hawkish Fed, even if it managed to eke out a rebound on Thursday. We have recently published on the risks to global growth, and the weak European PMIs seem like a consequence of these developments. We expect the euro's bull market to pause until global growth picks back up. Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Recent data in Japan has been mixed: Imports yearly growth underperformed expectations, coming in at 7.9%. It also declined significantly from the previous 14.9% pace . Moreover, Nikkei Manufacturing PMI underperformed expectations, coming in at 54. It also declined from 54.8 in the previous month, However, exports yearly growth outperformed expectations, coming in at 12.2%. It also increased from its 9.3% pace the previous month. USD/JPY has rallied by roughly 1.5% since last week. Overall, we expect that the current volatile environment will provide strength to the yen to the point that a level of 100 for USD/JPY is plausible. However, on a long term basis the yen is likely to be weak against the U.S. dollar, as the BoJ will fight tooth and nail to prevent a strengthening yen from hampering inflation. Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Recent data in the U.K. has been mixed: The ILO Unemployment rate surprised negatively, coming in at 4.4%. It also increased form 4.3% the previous month. Moreover, retail sales and retail sales ex-fuel annual growth also underperformed, coming in at 1.6% and 1.5% respectively. However, average hourly earnings yearly growth excluding bonus outperformed expectations, coming in at 2.5% GBP/USD has depreciated by nearly 1.6% this week. There are currently 45 basis points of hikes by the BoE priced into the next 12-months. We believe that there is not much more upside beyond this, given that the end of the pound's collapse will weigh on inflation. Moreover, recent data has shown that although inflation is high, the economy rests on a shaky foundation. We continue to expect the pound to fall on a trade-weighted basis as well. Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Data out of Australia was mixed: The Westpac Leading Index stayed steady at -0.2%; Wage growth beat expectations, growing at a 0.6% quarterly rate, and 2.1% annual rate; Construction work done slowed down severely, contacting by -19.4%, greatly surpassing the expected 10% contraction. It should also be noted that much of the wage growth was driven by the growth in public sector wages, which grew by 2.4% as opposed to the 1.9% growth experienced by the private sector. RBA members highlighted the risks created by lower than expected wage growth: weaker household consumption as a below-target inflation. The RBA is therefore likely to stay put this year, and the AUD will underperform its G10 peers. Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar The kiwi has fallen by roughly 1% this week, in part due to dollar rebound in the greenback. Nevertheless, AUD/NZD has declined by 0.6%, and is now down almost 3% during the year, thanks to dairy prices surging by more than 13% in 2018. Overall, we expect that the NZD will outperform the AUD, given that the consumer sector in China should outperform the industrial sector, as the Chinese authorities are cracking on overcapacity. With this being said, NZD/JPY will probably see downside, as the current volatility in markets will weigh on this cross. Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Canadian data was weak: Wholesale sales contracted by 0.5% at a monthly pace; Retail sales contracted by 0.8%, underperforming expectations; Core retail sales, excluding autos, contracted by 1.8%. The CAD weakened against all currencies this week. However, even if it may not increase much against the U.S. dollar, the case for a stronger CAD against other major currencies is still firm as the BoC is likely to hike interest rates more than most central banks year. Additionally, stronger U.S. growth should support the health of the Canadian export sector. Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Recent data in Switzerland has been mixed: The trade balance underperformed expectation on January, coming in at CHF1.324 billion. It also declined from last month's value of CHF3.374 billion. However, industrial production yearly growth increased from last month, coming in at a stunning 19.6% pace. EUR/CHF has been relatively flat this week. Overall we believe that the franc can only rally against the euro on episodes of rising global volatility, given that the SNB will fight against any appreciation of the franc that could hurt the little progress that has been made in achieving their inflation target. Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone USD/NOK has rallied by roughly 1.3% on the back of a stronger dollar. Overall, we believe that the krone should be the best performer amongst the commodity currencies, as the economic situation has improved substantially, with the Labour Survey improving last month. This will help the Norges Bank to tighten monetary policy more than the market currently expects. Investors who want to take advantage of these developments should short CAD/NOK as an oil-neutral bet. More audacious traders could short AUD/NOK or NZD/NOK as well. Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Swedish inflation dropped by more than expected: in monthly terms, inflation contracted by 0.8%, while in annual terms it grew by only 1.6%, less than the expected 1.8%. However, this monthly contraction was in line with the seasonal pattern historically witnessed in Swedish inflation, which also tells us that inflation is likely to pick up again in the following months. EUR/SEK hit 10, an historically very strong overhead resistance, indicating that markets may be unnerved by the Riksbank's unwillingness or inability to tighten policy. While the OIS curve is pricing in 80 bps of hikes in the next two years, we believe that the Riksbank will hike more than that, as inflation will come back to Sweden with a vengeance. Not only is the economy firing on all fronts, but the currency is also very cheap. The SEK is likely to strengthen this year. Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Chart I-7Slowdown In ##br##China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations