Economy
Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (Chart 4). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Chart 5S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. 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 Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.
Highlights Global credit markets have endured a surprising bit of turbulence over the past month. Credit spreads in a variety of markets, from U.S. High-Yield (HY) to Euro Area Investment Grade (IG) to Emerging Markets (EM) corporate debt, have widened for the first time since August. Outflows from dedicated corporate bond funds helped fuel the sell-off, with a reported $6.8 billion pulled from U.S. high-yield mutual funds and ETFs over the past week according to Reuters.1 Feature This volatility in credit markets spooked other asset classes last week, triggering a few days of equity market weakness. That is no surprise given the reliable and well-known leading relationship between corporate bond spreads and equity values. For markets that are priced for perfection, with tight credit spreads and elevated equity market valuations at a time when global central banks are inching towards a less accommodative policy stance, it may not take much to prompt some nervous selling by investors. Was this risk-off move justified by any renewed deterioration in credit fundamentals? Or was it just a correction in a market that was very overdue for one? To try and answer this, we think this is an ideal time to present an update of our Corporate Health Monitor (CHM) Chartbook. Chart 1Credit Markets Priced For Perfection Our CHMs are composite indicators of balance sheet and income statement ratios designed to assess the financial well-being of the overall non-financial corporate sectors in the U.S., Europe and Emerging Markets (EM). We have developed both top-down (based on profit data from national income/GDP accounts) and bottom-up (based on actual reported financial data of individual companies) versions of the CHM. While there are differences in methodology between the two measures due to data availability and coverage (see Appendix 1 on Page 13 for details), we have found that both are useful in providing a more complete and comprehensive assessment of the state of corporate finances. The broad conclusion from the latest readings on our Developed Markets CHMs paint a mixed picture (Chart 1): Medium-term credit quality in the U.S. continues to deteriorate, especially for high-yield borrowers, although there has been some cyclical improvement on the back of the solid cyclical performance of U.S. profit growth. Euro Area corporate health remains in good shape, supported in no small part by the hyper-accommodative policy stance of the European Central Bank (ECB) that includes corporate bond purchases. Although returns on capital remain poor and leverage has increased in the Peripheral economies. U.K. corporates are enjoying very strong liquidity positions that are boosting overall credit quality despite mediocre underlying earnings performance. With the global economy enjoying a coordinated cyclical upturn that is supporting solid earnings growth, combined with global monetary policy settings that still accommodative, corporate health is not the primary driver of credit market returns at the moment. Yet if the BCA view on global growth, inflation and interest rates plays out in 2018 - all moving higher, especially in the U.S. - then the story is likely to change. Investors who have been piling into credit because of low risk-free interest rates (and spillovers from global central bank asset purchases) will begin to worry more about credit fundamentals than simply chasing higher yields, to the detriment of credit market performance. U.S. Corporate Health Monitors: Still Deteriorating Our top-down CHM for the U.S. has now been in the "deteriorating health" region for thirteen consecutive quarters dating back to the middle of 2014 (Chart 2). The current U.S. economic expansion has boosted corporate earnings growth on a cyclical basis. This has only acted to slow the modest decline in top-down profit margins, and much larger fall in return on capital, since the peak in both ratios three years ago. The reading on the latter from the 2nd quarter of 2017 (the last data available) is only 6%, not far from the lows seen during the past two recessions. The low return on capital during the current cycle is a disturbing development, as it suggests that there has is a surplus of capital on U.S. balance sheets that is largely unproductive and not boosting profits (the numerator in the ratio). This can also be seen in the run-up in corporate borrowing in recent years that has been used strictly to do share buy-backs. If the best investment idea that a company can have is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the internal rate of return on that investment (i.e. the return on capital) must indeed be quite low, which is a longer-term problem for corporate health. Short-term liquidity remains in good shape for U.S. companies, but interest coverage remains near the low end of the historical range of this ratio. This combination suggests that U.S. companies are not facing an imminent cash crunch that could raise downgrade/default risk, but there is less room for error than in years when interest coverage was at higher levels. This can also be seen in the bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Interest coverage is at historically depressed levels for the U.S. HY names in our indicator, and has fallen back to just slightly above the levels seen prior to the 2009 recession. Leverage levels are much higher in HY - around 180% debt/equity (at book value) compared to around 100% for IG - with profit margins that are ½ as wide as those of the IG names in our CHM universe. Thus, it is no surprise to see a far worse interest coverage ratio within our HY CHM where most components are near historically "bad" levels for credit quality. Chart 2Top-Down U.S. CHM:##BR##Still Deteriorating Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Still Deteriorating What is rather worrying is the fact that U.S. IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This suggests that the stock of debt has now grown so much after the rapid run-up in leverage (i.e. record bond issuance) that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is robust. This will raise downgrade risk if corporate borrowing rates were to rise significantly or the U.S. experiences a major economic downturn, as interest costs would rise while earnings deteriorate. Given our views on the likelihood of additional Fed rate hikes and higher Treasury yields in 2018, with even a possibility of a Fed-induced recession in 2019 if policy is tightened too aggressively to combat rising inflation, the risks to U.S. corporate debt performance (both IG and HY) will grow over the course of next year. For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after there is more decisive evidence that rising realized inflation is boosting inflation expectations, which will give the Fed confidence to tighten policy more aggressively. This will dampen future corporate profit expectations and likely raise risk premiums on U.S. corporate bonds. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Modest Cyclical Improvement, From Very Bad Levels Chart 5Credit Rally##BR##Losing Momentum? One final point on the U.S. CHMs - in this version of the CHM Chartbook, we are adding some additional charts showing the bottom-up CHMs for some selected corporate bond sectors. These can be found in Appendix 2 on Page 13. We are only showing the charts this time, but we do plan on doing deeper dives on some individual sectors in future Weekly Reports and CHM Chartbooks. Euro Area CHMs: Still O.K., But With Some Mixed Signals Our top-down Euro Area CHM remains in "improving health" territory as it has for the entire period since the Global Financial Crisis. The direction is turning a bit more worrisome, though, as the indicator is now the closest it's been to the zero line since 2013 (Chart 6). By construction, the CHM shows deviations of the indicator from recent trends, in order to more quickly capture turning points in credit quality. Looked in that light, the steady worsening of the top-down CHM is a function of recent declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity levels and interest coverage. The latter two points are directly related to the easy money policies of the ECB. The combination of zero (and even negative) short-term interest rates, specific liquidity programs aimed to prompt low-cost bank lending, and outright ECB asset purchases of Euro Area corporate debt have all helped drive borrowing rates to record low levels. Perhaps surprisingly, the low return on capital in the Euro Area, around 8%, is still above the return on capital from the U.S. top-down CHM of 6%. This is also confirmed by the bottom-up versions of the Euro Area CHMs for IG corporates (Chart 7) and HY corporates (Chart 8). Return on capital for Euro Area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, a healthy number by any measure and similar to the level in the bottom-up U.S. IG CHM. Even Euro Area HY shows a return on capital of 4-6%, similar to that of U.S. HY. Chart 6Top-Down Euro Area CHM:##BR##Trending In A Bad Direction Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Improving Within the countries of the Euro Area, our bottom-up CHMs show that the credit metrics look better for the Core versus the Periphery (Chart 9). The biggest difference comes from a cyclical improvement in profit margins and interest coverage in the Core that is not being matched in the Periphery. Chart 8Bottom-Up Euro Area##BR##High-Yield CHMs: Looking Much Better Chart 9Bottom-Up Euro Area##BR##IG CHMs: Core Vs. Periphery More broadly, European corporate health seems to be improving when looking at our bottom-up CHMs. This goes against the trend we are seeing in the top-down CHM, although the latter is still in the "improving health" zone. Declining leverage, especially among the HY issuers in our bottom-up universe, appears to be the biggest source of the HY CHM improvement - again, a bit of a surprising result given how low the cost of debt finance currently is in Europe. Looking ahead, the outlook for Euro Area corporate credit looks positive in the near term, but murkier after that. The current powerful cyclical upturn in the European economy is likely to continue in 2018, as is the ECB's highly accommodative monetary policy. But at some point in the middle of next year, the ECB will be having the same discussion with the markets that was conducted over the past few months, regarding the future of the central bank's asset purchase program. This time, we think the growth and inflation data will give the ECB no choice but to announce a full tapering of its bond-buying program by the end of 2018. Interest rate hikes will come after that, but with a lag of at least one full year. European government bond yields will rise as the ECB eventually stops its asset purchases and the market pulls forward the timing of the next ECB rate hiking cycle. This also applies to corporate debt, where the ECB has become a massive buyer over the past three years. As the pace of ECB buying diminishes, Euro Area corporate bond yields should begin to rise and credit spreads will widen (Chart 10). The underlying improvements in our bottom-up Euro Area CHMs suggests that the repricing of European credit post-ECB tapering may be relatively contained. We still prefer to own U.S. corporate credit over Euro Area equivalents at this time, though. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although of late only U.S. IG corporates have outperformed Euro Area corporates. European HY has been outperforming in 2018 (in excess return terms), which may be a sign that investors are seeing the better European credit health that our bottom-up CHM is showing. Chart 10European Credit##BR##Looks Fully Valued Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: No Major Causes For Concern The top-down U.K. CHM has been in the "improving health" zone for the past two years, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop (although at levels not far off those seen in the U.S. and Europe). U.K. credit has enjoyed the same global liquidity tailwind that other corporate bond markets have enjoyed. This is doubly so because of the specific easy monetary policies of the Bank of England (BoE) after the 2016 Brexit vote. The BoE has already reversed the post-Brexit interest rate cut, although additional hikes are highly unlikely given muddled growth momentum and the lingering uncertainties over the Brexit negotiations. The post-Brexit weakness in the British pound has stabilized, with the trade-weighted exchange rate now in positive territory on a year-over-year basis. This will result in slower inflation rates in the coming months and a BoE that is likely to sit on its hands for a while. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet at current low yield and spread levels, it is difficult to paint a scenario of additional outperformance of U.K. credit without a catalyst like accelerating growth or monetary easing. The combination of accommodative monetary policy and a solid credit backdrop, as indicated by our U.K. CHM, leads us to maintain our current neutral allocation to U.K. corporate debt, even though valuations do not look particularly cheap (Chart 13). Chart 12U.K. Corporate Health Monitor:##BR##Credit Quality Still Improving Chart 13U.K. Credit Rally Starting##BR##To Lose Steam Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.reuters.com/article/us-markets-flows-baml/investors-yank-6-8-billion-from-high-yield-bonds-third-largest-outflows-baml-idUSKBN1DH1G8 Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.2 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team in September 2016, which extends the CHM analysis to EM hard-currency corporate debt.3 2 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors 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 The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.