Economy
Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation
Highlights Hurricane Harvey will prove a bigger market-mover than North Korea's latest missile test; The worst flood in Houston's history will improve U.S. policymaking and remove domestic risks; North Korea justifies hedging against violent incidents, but actors are constrained from full-scale war; Insights from our travels in Asia suggest that U.S.-China cooperation is still meaningful. China's reform reboot faces constraints; Abenomics is not done yet. Feature As we go to press, two crises are developing. The one that has rattled the markets - and that we focus on in this Weekly Report - is the North Korean missile launch. However, we think the more investment-relevant one is the slow-moving Hurricane Harvey, which is about to inundate Houston - a metropolitan area with nearly 7 million people - with more rain. We cannot predict the ultimate impact on the economy of the developing natural disaster, but we do know that Houston is experiencing the greatest flood in its history. The scale of human suffering is likely being massively underestimated at present. Comparisons with Hurricane Katrina are not without merit, but Houston has a population about five times that of New Orleans. Investors may rightly ask, so what? The stock market actually rallied at the height of Hurricane Katrina and one would struggle to pick its date on a chart of the S&P 500. The impact on the economy and markets is likely to be tepid in the near term once again. The significance of Hurricane Harvey is its likely impact on politics. First, there is now no chance that the debt ceiling will be breached. We discussed the low odds last week and we reiterate them here. Second, odds are that a government shutdown is unlikely as well. It is unfathomable to shut down the government during an emergency. Imagine if the Federal Emergency Management Agency (FEMA) had to cease operations. Wall or no wall on the Mexican border, Republicans in Congress and the White House will fund the government. More than that, Americans suffering in a Red State that voted for President Trump could be the catalyst that Republicans need to put their intra-party differences aside and start working with vigor on legislation, including tax reform. We could even contemplate legislative action on a bipartisan infrastructure plan, although the ability of U.S. policymakers to put aside grief and focus back on partisan bickering never ceases to amaze. The bottom line for us is that in six months' time, when investors look back on late August 2017, it will be Hurricane Harvey that is cited as having been market-relevant in the long term, not North Korea's n-th missile launch. That said, North Korea remains relevant. It has launched an avowed ballistic missile over Japan for the first time (as opposed to a space launch vehicle, which it has done in 1998 and 2009). The launch originated near Pyongyang, a warning to the U.S. that any strikes against launch sites would be complex (involving civilians) and tantamount to an attack on the capital and a declaration of war. The United States and its allies will be forced to respond to this brinkmanship by trying harder to establish that the military option is indeed credible despite the well-known constraints (the decimation of Seoul). Therefore more market volatility will ensue in the coming months and year. We do not rule out major violent incidents, though full-scale war still seems highly unlikely due to hard constraints on the various actors. (Please see "Appendix" for our updated checklist on whether the U.S. will attack.) While we do not expect either Pyongyang or Hurricane Harvey to derail the bull market, we recognize that valuations are stretched, volatility is low, and the market may be looking for a reason to sell off significantly. In this report, we discuss insights on North Korea and other key issues gleaned from our recent travels abroad. BCA's Geopolitical Strategy went on the road this summer for five weeks. We visited the American Midwest, Australia, New Zealand, Singapore, Taiwan, China, Japan, South Korea and the U.K. There we had the pleasure of speaking with clients across the asset management industry. Each region had its own set of specific questions and concerns, as well as insights. Over the next two weeks, we plan to share these with our entire client base. Going on the road is critical for investment strategists. It is an opportunity to stress-test and sharpen one's view through interaction with sophisticated investors. Meeting clients also ensures that you are asking the right questions. We are happy to report that our three main questions - how stimulative will U.S. tax reform be; is China willing to deleverage; and is Italy a potential source of global risk-off - are indeed on all of our clients' minds. This does not mean that everyone came to the same conclusions that we did, but at least we know that we are looking for the same answers. Sino-American Split Is Overstated Investors are no longer as quick to dismiss one of our central geopolitical theses: that the U.S. and China are on a path likely to end in the "Thucydides Trap."1 However, one of our clients was not so sure that U.S.-China relations are deteriorating as rapidly as they appear to be. He observed a pattern in bilateral trade that suggested to him that the two countries are working together, under the table, to keep relations from collapsing despite the unprecedented challenges posed by the post-2008 global political and economic environment. He began with the simple point that the U.S.'s rising trade protectionism against Chinese steel in recent years actually made it easier for President Xi to take aim at overcapacity problems in the steel sector in China. After U.S. steel imports from China collapsed, from 20% of total in 2008 to 3% in 2016, China was able to embark on a long-delayed purge of excess steel capacity, shutting down a reported 87mmt over the past year and a half (Chart 1). China moved up the steel product value chain partly as a result of U.S. actions.2 China also appears to have responded promptly to U.S. complaints about agricultural imports. In late 2016, amid a heated and protectionist presidential campaign, the U.S. government threatened to impose tariffs on China's grain exports and demanded that subsidies be removed so that U.S. companies could compete on a level playing field in China's domestic market. Corn prices were at a nine-year low; Beijing was giving rebates to domestic corn exporters and had amassed large corn inventories. Within a few months, in March 2017, China launched the agricultural side of its supply-side reforms. It removed the supports for corn, allowing prices to plummet and making way for lower Chinese supply and thus more U.S. imports (Chart 2). Chart 1U.S. And China Attack Chinese Steel Capacity Chart 2China's Supply-Side Agriculture Reforms Most recently, the client emphasized, China launched one of its periodic crackdowns on intellectual property violations.3 Enforcement was observable in China's mainstream online services, which largely lost the ability to stream content for which they lacked the rights.4 As with steel, China has a self-interest in these reforms, especially as it generates its own intellectual property. But it cannot have detracted from China's urgency that the U.S. announced a formal investigation in early August to determine whether China's intellectual property violations deserve punitive actions.5 It is as if China anticipated the U.S.'s moves coming out of the U.S.-China Comprehensive Economic Dialogue in July. In these and many other cases, a pattern seems to emerge: U.S. trade grievances boil up, U.S. authorities threaten punitive actions, China responds to the threat by vowing retaliation and pushing through supply-side reforms that are already in its interest. The process appears to be a win-win, however precarious. The client also suggested that the U.S. may be offering to become more constructive toward certain Chinese initiatives. For instance, China is pressing forward on the long-delayed launch of an oil futures contract on the Shanghai International Energy Exchange in the second half of 2017. This new benchmark would ostensibly rival Brent and West Texas Intermediate contracts and be settled in RMB instead of USD. To our client, China's moving forward with this scheme, immediately after top-level trade negotiations with the U.S., seemed to reveal the U.S.'s tacit support for RMB internationalization. Certainly the U.S. nodded at the IMF including the RMB in its special drawing rights basket.6 Presumably, then, the U.S. and China have not entirely lost the ability to deal with each other on sensitive issues in an atmosphere fraught with distrust. Moreover, both sides can attempt to roll with the punches. China can blame the difficulties of necessary internal reforms on U.S. protectionism, while U.S. protectionist impulses can be mitigated via China's internal reforms. This dynamic could become the silver lining in Sino-American relations in 2018, a year in which Xi will have the best opportunity to push reforms while Trump may be most eager to take protectionist actions ahead of the midterm election. A silver lining to a black cloud, of course. Bottom Line: Risks to Sino-American relations remain serious, but the two sides still retain some ability to manage tensions. The question is how much ability? Our own view has been that 2017 would largely be a year of Trump issuing "a shot across the bow" and then negotiating. Concrete, aggressive action would be more likely to occur in 2018. This remains our baseline case. But silent coordination of the kind described above could perhaps improve trade relations enough to satisfy Trump in 2018 and delay a Sino-U.S. confrontation. China has long dealt with protectionist threats from the U.S. by conceding various reforms and policy adjustments, especially by increasing U.S. imports. The U.S. has long accepted such a response. We doubt that this tactic will be enough in this day and age, but maybe so. North Korea Could Cause A Recession What about U.S.-China cooperation on North Korea? It appears as if coordination has improved in the face of a potential conflict. At the peak of tensions this summer, China has offered to implement sanctions, cutting off some trade and joint ventures, while the U.S. has given reassurances about U.S. military intentions in the event of a conflict.7 However, judging by conversations with clients on the mainland, a large gap still exists between U.S. and Chinese perceptions. In particular, Chinese clients pushed back against any implication that China is responsible for reining in North Korea's bad behavior. They highlighted China's emphasis on national autonomy, the idea that every country should be left alone to address its own problems in its own jurisdiction. Otherwise countries should resolve differences through diplomacy and dialogue, conducted as equals. The threat or use of force always makes things worse. The current North Korean situation is, from this perspective, America's fault. The North Koreans pursue nuclear-tipped ballistic missiles in order to deter a U.S. attack, having seen what happened to other nuclear aspirants like Iraq, Syria, and most recently Libya.8 In short, China sympathizes with its formal ally North Korea. It demands peaceful negotiations and denounces the threat of regime change. And it does not believe U.S. officials when they renounce regime change as an option, as Secretary of State Rex Tillerson has recently done. "No one will believe that," one of our clients said, and least of all North Korea. (Quite reasonably, we would add.) This argument reinforces our view that China will not impose crippling sanctions on the North, even if it tries to pressure Pyongyang back to the negotiating table. Since the North cannot be expected to give up its nuclear weapons, the negotiations themselves will be limited from the outset. The U.S. essentially has to accept the status quo, possibly even the perpetual threat of a North Korean nuclear strike. This, in turn, increases the probability that the Trump administration will be disappointed with the outcome. Which is precisely why we expect the U.S. not only to bulk up its military alliance in the region but also to impose more "secondary sanctions" and trade tariffs on China. Sino-American tensions will get harder and harder to manage. While we can foresee skirmishes and violent incidents, we think the probability of a full-scale Second Korean War is low. Diplomacy is not exhausted, the U.S. alliance with regional powers remains intact, and, most importantly, North Korea has not committed an act of war (or acted as if it is about to, which would prompt U.S. preemption). Regarding the big picture, some of our clients are not so sanguine. One of them pointed out recent academic research arguing that armed conflict, as a cause of death in the human population, has declined. The number of violent deaths per 100,000 people has fallen from historic levels in the hundreds down to an average of 60 in the twentieth century, which includes two world wars, and down to the single digits in the post-WWII era (Chart 3). The client asks: Is this drop in war deaths sustainable? The implication is that the level of deaths has nowhere to go but up. Chart 3Human Deaths By War Have Collapsed In Post-WWII Era The client coupled this thought with another bearish theory. It is widely known that recessions are normally preceded by large financial or economic imbalances. Today many investors are encouraged by the apparent lack of any such imbalance. They read this as saying, "let the good times roll." Our client viewed it another way, suggesting that the imbalance that will cause the next major recession will be non-financial and non-economic, e.g. ecological, epidemiological, geopolitical, etc. Chart 4Global Conflicts Increasing In Frequency The client was not specifically hinting at a North Korean conflagration, though probably not ruling it out either. He was mostly concerned with the historic drop in deaths by conflict and how it might be reversed in the near future. Unfortunately this bleak suggestion that war might make a secular comeback is not incompatible with our view that geopolitical multipolarity goes hand in hand with a higher incidence of internationalized conflicts (Chart 4), which could be exacerbated by a decline in global trade. On the other hand, the fall in deaths is a product of a range of political, economic, social and scientific advances, and may not be reversed through geopolitical tensions alone. Bottom Line: The U.S. and China remain far apart in their perceptions of who is to blame for North Korea and what is to be done. China will not take responsibility for "solving" the problem as the U.S. demands. This reinforces our view that North Korean tensions have not yet peaked and remain market-relevant. We ultimately believe that a peaceful solution will prevail, but getting from here (tensions) to there (a negotiated settlement) entails further risks. China Will Try To Reform, But Won't Touch The Property Bubble "They've got to do something about the corporate leverage." This was the conclusion of a client who agreed with our view that President Xi Jinping will likely accelerate his reform agenda after the nineteenth National Party Congress this fall, and that deleveraging is the key indicator (Chart 5). Some clients in China - specifically banks - confirmed that they were under pressure from tightening financial regulation and as a result were both slowing the pace of lending and becoming more scrutinizing of borrowers' creditworthiness. Borrowing rates have ticked up (Chart 6). Chart 5High Time For Some Belt-Tightening Chart 6Chinese Cost Of Capital Ticks Up Clients also suggested that Chinese leaders would soon re-emphasize the country's transition away from GDP targets as a measure of successful governance and economic stewardship. When the Xi administration came to power, it sought to de-emphasize GDP targets and introduced new and alternative targets - such as urban and rural income per capita, labor productivity, corruption, air pollution - into its assessments of economic progress. But the administration was forced to return to GDP targets amid growth fears in 2015, prompting Premier Li Keqiang to promise "at least" 6.5% growth for the next five years. Now the attempt to elevate qualitative measures of governance looks set to resume. Xi held two meetings of the Central Leading Group for Deepening Overall Reform this summer, in which he noticeably prioritized "green growth" rather than plain old growth, and pushed for replicating and applying more broadly the pilot reforms that have been implemented since his reform agenda was first laid out in 2013. In mid-July, at the National Financial Work Conference, Xi called for local officials to be held accountable for local government debt - even beyond their term in office. And in late July, Yang Weimin, a key economic policymaker who reports to Xi, said, "we won't allow the leverage ratio to rise for the sake of maintaining growth."9 The implication is that GDP growth will be allowed to fall as the government attempts to make progress on difficult reform initiatives. Chart 7Bonds More Important In China Several clients also expressed confidence that China would resume economic "opening up" before long. It is well known that, over the past year, Beijing has sought to attract FDI by promising to implement a nationwide "negative list" and removing certain sub-sectors from that list, in a bid to counter recent weak FDI inflows and ongoing capital outflow pressure. Beijing has also taken steps to deepen its financial sector, such as by expanding and regularizing its bond markets (Chart 7) in preparation for opening the Hong Kong-Shanghai "bond connect," which will allow foreign investors to buy Chinese bonds and, we think, generate strong demand. To add to this list, clients stressed that China is beginning to think about what happens after it lifts the capital controls put in place last year to halt outflows. A number of institutions are interested in expanding their overseas portfolios when they get the "all clear." We would expect the re-opening to come after the central government completes a round of reforming, recapitalizing, and restructuring banks and SOEs, which could push the timing well into 2018 or 2019. But clients are clearly chomping at the bit - which may suggest that they anticipate capital controls to be lifted sooner rather than later. One important reform item that we were told not to expect is the imposition of a nationwide property tax. Chinese authorities delayed the implementation of the tax in 2016 due to the desire to reflate the property market. Presumably they will return to this initiative now that the economy has recovered: it makes long-term sense to give local governments a more stable source of revenue and to suck some air out of the property bubble gradually so that it does not burst (Chart 8). However, clients are skeptical about any reforms that could harshly suppress real estate prices due to the heavy concentration of household wealth in the property sector (Chart 9). Chart 8Provinces To Be Weaned Off Of Land Sales? Chart 9Chinese Wealth Stored In Housing If the property bubble should be popped, people's life savings would vanish into thin air and there would be chaos in the streets. A client in Hong Kong remarked that the Chinese public will pretty much accept anything as long as property prices continue to rise. Since everyone agrees that social stability is the critical aim of the ruling party, it stands to reason that reforms will not be allowed to threaten the property sector, at least not directly. If the property sector prevents serious attempts at deleveraging, then the environmental agenda will become all the more significant as the focus of the Xi administration in its second five-year term. The administration began by increasing central government spending for environmental regulation more than for any other category of spending (Table 1). And Xi's statements in July, previewing the National Party Congress, emphasized fighting pollution as one of three chief focal points (the others were controlling systemic risks and fighting poverty). Table 1Fiscal Priorities Of Recent Chinese Presidents In recent months, central inspectors have fanned out across the country to conduct local pollution inspections ahead of end-of-year deadlines. These have fueled market speculation about deep curbs coming to industrial overcapacity, causing the prices of certain commodities that China produces, like aluminum, to surge (Chart 10). These commodity prices have likely already seen the biggest moves - given China's sharp slowdown in 2014 and reflation in 2015-16 - but they are still sensitive to the policy mix in China, i.e. the relative amounts of capacity cuts and deleveraging that take place. Chart 10Supply-Side Reform Has Boosted Metals Bottom Line: Clients across the Asia-Pacific region were focused on the question of Chinese structural reforms. We got the sense that there was much skepticism over whether they would indeed be growth-constraining. But when pushed, clients focused on real estate prices as the one threshold policymakers would not dare to cross in China. What About Japan? A Visit With Mr. K One of our most esteemed clients is a seasoned Japanese global investor who shall go by the moniker of "Mr. K" in the following dialogue (and for future reference). Mr. K opened the dialogue with us by asking us for our view of Japan. Mr. K: What is your view on my country, on Japan? GPS: We tend to think that the current reflationary policy will continue. The Tokyo metropolitan elections did not sound the death knell for Prime Minister Shinzo Abe (Chart 11). The BoJ has become more, not less, dovish, and is not likely to follow other central banks in tightening policy anytime soon. Abe retains control of both houses of the Diet and can increase government spending to boost the economy. And the LDP will continue reflation even if Abe falls. Mr. K: This may be true, reflation will continue. However, the Japanese economy is reaching a plateau after five years of Abenomics. The recent strong GDP numbers were not well-received because consumers feel the stagnation (Chart 12). Global demand, and Chinese demand, have provided a positive backdrop for Japanese manufacturers, but the domestic outlook is not wildly optimistic. Chart 11Abe No Longer In Free-Fall Chart 12Japanese Feel Stagnant Despite Strong Growth With economic policy, the key phrase is "TINA," There Is No Alternative. There is no alternative to Abe at the moment. If you look back at the Democratic Party of Japan's support in 2011 under Prime Minister Yoshihiko Noda, it was a real contender. Today, it is far from rivaling the LDP (Chart 13). The voting population is, apparently, comfortable. It is true that if Abe leaves, it will not make much of a difference, as long as the LDP remains in power. The younger generations do not seem troubled by the current state of affairs. They are well-trained to endure economic stagnation. There is a sense that those who stand out feel uncomfortable. College graduates looking for jobs are very conservative. While with Generation X there was always the expectation that tomorrow would be a brighter day, Generation Millennial has come not only to accept stagnation, but even to like the stability of flat growth. GPS: Isn't this kind of stagnation a good thing? Isn't it a case of Japan being in a "Goldilocks" phase? Mr. K: Stability and stagnation can be good for markets. First, the macro environment is decent. Corporations have large cash balances, external demand is strong, wage demand is subdued, and the exchange rate is weak. However, risk-taking is not prized, whether in the education system or the media. Public discourse tends to discourage high-risk investments. And risk-takers have not been properly rewarded over the past two decades in Japan (Chart 14), so confidence and risk-appetite are weak. Also, deflation is hard to defeat. The "100 Yen Shop" (dollar store) retail model is a good example. The goods are all cheap, but as long as you can bring more people in, you can make a profit. This is almost all deflationary. Moreover, the Japanese have nothing to spend on! They no longer need new cars, or big computers; they just need mobile phones, maybe a Nintendo Switch, etc. Second, as to the financial markets, greater deregulation is necessary to attract non-Japanese capital flows. Maybe then valuations will normalize (Chart 15). It is essential to see if leading companies continue to gain global competitiveness, in anything from Internet services to gaming. Watch valuations and watch cash flow. Chart 13Opposition Still Can't Touch Ruling LDP Chart 14Risk-Takers Punished In Japan Chart 15Japanese Valuations Still Low The key firms are not necessarily the keiretsu, but secondary or new manufacturers that are driving growth. Small caps are more leveraged to foreign exchange, whereas neither the Japanese domestic economy nor the value of the yen matter much to large multinationals anymore. To capitalize on the internal economy you want to be long small caps. Or better yet, long semi-large caps: those companies equivalent to the U.S. companies that make the difference between the S&P 500 and the S&P 600. These are some of the best plays in Japan because they are domestic-oriented and sensitive to the weaker yen. This will provide a tailwind for stocks elsewhere. Local property markets also offer a very good return over the risk-free rate. GPS: What do you make of our view that Abe will push reflationary policy ahead of his efforts to revise the constitution? Given that he needs a strong economy to pass the popular referendum? Mr. K: It is harder to increase fiscal spending in Japan than one might think. However, the North Korean threat is not going anywhere. And the media love "tensions." GPS: So it seems like you are positive about the markets in Japan, but are not yet sold on Abenomics? Mr. K: I suppose the lesson is, if it isn't too cold, stay on the ski slopes. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For this term, please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, as well as Allison's new book, Destined For War: Can America and China Escape Thucydides's Trap? (New York: Houghton Mifflin Harcourt, 2017). 2 Please see BCA China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge," dated August 17, 2017, available at cis.bcaresearch.com. 4 Please see "China cracks down on distribution of illegal publications," Xinhua, July 25, 2017, available at news.xinhuanet.com. China also highlighted the BRICS countries' joint efforts at enforcing intellectual property as it prepared to host the BRICS conference in Xiamen, Fujian in September. Please see Ministry of Commerce, "Ministry Of Commerce Holds Press Conference on 2017 BRICS Trade Ministers' Meeting," August 4, 2017, available at english.mofcom.gov.cn. 5 Please see the Office of the United States Trade Representative, "USTR Announces Initiation of Section 301 Investigation of China," August 2017, available at ustr.gov. 6 Other examples of U.S. cooperation with Chinese initiatives include the U.S. sending a small delegation to take part in the One Belt One Road (OBOR) conference in May. 7 In particular, Chairman of the Joint Chiefs of Staff Dunsford visited China, met with the Central Military Commission, and vowed to improve military-to-military relations. 8 Or a country like Ukraine, which agreed to give up its nuclear arsenal as soon as it became independent in 1994, only to see its territory carved up by global powers 20 years later (13 years after it emptied its missile silos). 9 Please see Sidney Leng, "China shifts gear from growth to debt cuts in race against rising tide of red ink," South China Morning Post, July 27, 2017, available at www.scmp.com. Appendix Table 2Will The U.S. Attack North Korea? Geopolitical Calendar
Highlights The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. Our negative outlook for China's capital spending and imports will be wrong if the money velocity or the money multiplier or productivity growth rise materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity would be highly speculative and unreasonable. With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Feature Chart I-1EM Share Prices Are ##br##Facing A Technical Hurdle In this week's report we elaborate on the following interrelated questions: Where do EM economies stand in terms of their respective business cycles? What are the key drivers and risks to our view? EM share prices in U.S. dollar terms are facing another technical hurdle (Chart I-1). Even though EM risk assets have been trading well, we still find their risk-reward profile unattractive, and below we elaborate why. The EM Business Cycle EM economic data have differed greatly over the course of the current rally, and various economic parameters presently exhibit very different phases of the business cycle in developing economies. For example, Asian export growth has rolled over having expanded at a double-digit pace early this year (Chart I-2). In general, EM exports have posted a broad-based recovery: the recovery in Chinese, U.S. and European imports has helped Asian exports, while higher commodities prices have boosted export revenues of commodities producers. On the flip side, domestic demand in EM ex-China has been rather mediocre. In fact, there has been very little domestic demand recovery, as evidenced by retail sales and auto sales (Chart I-3). Importantly, bank loan growth has not recovered at all (Chart I-3, bottom panel). Based on the above, we can summarize the above divergences as follows: the global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Chart I-2Asian Export Growth ##br##Has Rolled Over Chart I-3EM ex-China: Domestic ##br##Demand Has Not Yet Recovered In turn, China's imports surge has been due to the revival in new money/credit origination that has been in play since the middle of 2015. China's commercial banks have originated about RMB 43 trillion of new money/credit in the past two years. This has greatly helped many developing countries selling to China, boosted commodities prices, creating fertile ground for capital flows to EM financial markets. Going forward, the pertinent question for the EM business cycle is which of the following two scenarios will likely play out: (1) China's imports relapse materially soon, weighing on commodities and other EMs and capping the recovery in their domestic demand; or (2) Chinese import growth holds and the recovery in EM ex-China domestic demand gains momentum. The first scenario entails a bearish outcome for EM share prices, while the second would imply a continuation of the EM rally. BCA's Emerging Markets Strategy team envisages the first scenario. The basis of our argument is that the deceleration that has already occurred in Chinese money growth combined with ongoing monetary tightening are about to cause a considerable slowdown in China's real economy and imports (Chart I-4). What about the other two pillars of global imports - the U.S. and Europe? U.S. imports have in the past year outpaced final sales to domestic purchasers (Chart I-5). As can be seen in this chart, imports are more volatile than domestic demand and this discrepancy is reflective of inventory cycles. After outpacing final domestic demand for the past seven months, odds are U.S. imports growth will moderate in the next 12 months. That said, we do not expect a contraction in U.S. imports. Even if European imports remain robust, a material slowdown in China and some moderation in U.S. imports will be sufficient to produce a slump in EM aggregate exports. The rationale is twofold: First, for many developing countries, China as a destination for shipments is larger than or as large as the U.S. and Europe combined. Chart I-4China: Money Growth And Business Cycle Chart I-5U.S. Import Growth to Moderate Second, mainland demand for raw materials is critical for their prices. In turn, the trend in commodities prices often defines EM financial markets dynamics. This is why we focus so much on China's credit/money cycle, which in turn drives China's capital spending and an overwhelming majority of its imports. Notably, the reason why Chinese imports are much more sensitive to credit compared to other EM and DM economies is because the mainland's imports consist of 42% of commodities and raw materials and 55% of capital goods. Hence, 97% of imports is for investment spending, with the latter financed and driven by money/credit. Bottom Line: The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. The Key Pillar Of Our View The key area where we differ from the bullish consensus on EM/China is our expectation that Chinese growth will slow before year-end due to a combination of ongoing policy tightening and lingering credit excesses. Regardless of which broad money measure we use - official M2, money calculated using commercial banks' liabilities (we refer to it as deposit-money or M3 hereafter) or banks' assets (we refer to this as credit-money) - the current message is the same: broad money growth has fallen to historic lows (Chart I-6). An imperative question is: what does the recent gap between broad money (our calculation of M3) and private (corporate and household) credit growth, as evidenced by the top panel of Chart I-7A, mean for investors? Chart I-6China: Various Versions Of Broad Money Chart I-7Comparing Broad Money And Credit Growth From the perspective of the outlook for growth, it is the aggregate of private and public credit that matters. When we substitute private credit with the aggregate of private and public credit, there does not appear to be much decoupling (Chart I-7, bottom panel). Readers should note that the historical time series for aggregate private and public credit is from BIS and the data for 2017 are our estimates based on general government fiscal deficit and total social financing. If past correlations between money, credit and economic growth and their respective time lags hold, the cyclical parts of the Chinese economy should slow down before year-end (Chart I-8). This differs from the consensus view on the street that a slowdown is not in the cards until well into next year (or later). China's currently flat yield curve also supports our view on imminent growth deceleration (Chart I-9). In fact, Chinese money market rates and onshore corporate bond yields have begun drifting higher following two to three months of consolidation. Chart I-8China: A Slowdown Before Year-End? Chart I-9China: Yield Curve And PMI Finally, we believe the depth of the impending slowdown will be material because ongoing liquidity tightening is occurring amid lingering credit excesses/credit bubble. While policymakers do not plan to push the economy into a vicious downturn, they may be open to the idea of attempting mild short-term deleveraging to contain risks in the long run. Furthermore, the Chinese authorities - like in any other country - may not have perfect foresight about the magnitude of a potential slowdown. Hence, their reversal of tightening policies is likely to be late, resulting in a rough spot in growth. Bottom Line: The key difference between our stance and the bullish view on EM is on China's growth trajectory and commodities prices. Risks To Our View Given that the main pillar of our view is that China's credit and money growth is driving mainland capital spending and imports, our recommended investment strategy will be wrong if the already transpiring slowdown in money growth does not translate into investment spending deceleration. This could happen because of the following: Strong nominal growth can coincide with slower money growth only if the velocity of money accelerates. In short, our view will be wrong if China's nominal output growth holds up or quickens, despite the slowdown in broad money growth that has already occurred. This could happen if the velocity of money suddenly shoots up - i.e., the same amount of money simply turns faster facilitating faster expansion of nominal output. There is no way to forecast changes in money velocity in any country in any period with any precision. As a rule, we (and the vast majority of other market participants) simply assume money velocity will be constant over our forecast horizons. Money velocity is calculated as nominal GDP divided by broad money supply. From a historical perspective, Chart I-10 demonstrates that China's money velocity has actually drifted lower in the past 10 years or so. Therefore, a material rise in China's money velocity would be an exception from the trend of past decade. Consequently, before assuming a rising money velocity, one needs to prove why it will escalate going forward. This does not mean it is impossible or could not happen, but it is reasonable to challenge the nature and timing of it. Our view will be wrong if money growth accelerates sharply from current levels without more liquidity (banks' excess reserves) provisioning by the People's Bank of China (PBoC). In such a scenario, broad money growth acceleration amid low levels of banks' excess reserves would signify a spike in the money multiplier. However, the money multiplier for China - measured as broad money divided by commercial banks' excess reserves at the central bank - is already at the second highest of the past ten years (Chart I-11, top panel). In level terms, there is currently about RMB 212 trillion of broad money - measured by commercial banks' liabilities/deposits (our measure of M3) versus RMB 2 trillion of commercial banks' excess reserves at the end of June. Chart I-10China: Velocity Of Money ##br##Has Been Drifting Lower Chart I-11China: Money Multiplier ##br##Is Already Elevated We assume the money multiplier will be flat to down in China over the next 12-18 months. Banks have already become overextended with respect to the money multiplier, and are operating on thin liquidity/excess reserves (Chart I-11, bottom panel). With interest rates rising and regulatory tightening forcing banks to bring off-balance-sheet assets onto their balance sheets, it is reasonable to assume a flat-to-down money multiplier. Finally, another risk to our view stems from productivity. If productivity growth is set to accelerate considerably in China, it will boost real output growth despite the slump in money/credit. Chart I-12China: Structural Slowdown ##br##In Productivity Growth It is hard to measure productivity ex-post, let alone to forecast it. This is especially true for developing economies. This is why we assume that productivity growth in China will be stable in the medium term but will decelerate in the long run if structural reforms are not implemented and the economy's reliance on abundant money/credit is not reduced. Simply put, when money/credit are plentiful, people and companies make a lot of money without working hard and innovating. This is why money/credit deluges and asset bubbles often lead to a considerable productivity slowdown in any country. Provided that China's economy has been primarily fueled by copious amounts of money and credit since early 2009, it is reasonable to assume that productivity growth has slowed (Chart I-12). Without structural reforms, the quality of capital allocation will not improve. Therefore, productivity growth is bound to slow rather than accelerate. We will discuss the structural outlook for China including productivity and economic rebalancing toward the service sector in a special report to be published in the coming weeks. Bottom Line: Our negative outlook for China's capital spending and imports will be wrong if the money velocity rises considerably or the money multiplier shoots up or productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity from current levels would be highly speculative and unreasonable. Risk Off And Fund Flows Into EM Last week we downgraded Korean stocks due to expectations that geopolitical tensions are set to rise in the near term. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.1 And that process could take more time, which means more volatility in the markets.2 The risk-off dynamics in EM due to tensions in the Korean Peninsula is a near-term risk and might become a trigger for a rollover in EM risk assets via reversal of portfolio flows. One of the narratives supporting the EM rally has been the changing composition of foreign capital flows into EM. This narrative argues3 that international flows to EM have been dominated by foreign direct investment (FDI) rather than portfolio inflows. This presages that EM risk assets are much less exposed to portfolio outflows than before. However, this is factually wrong. The composition of international capital flows into EM has been dominated by portfolio flows rather than FDI. In fact, FDI inflows have not yet recovered (Chart I-13). For the calculation of this aggregate we exclude not only China, Korea and Taiwan - which have large current account surpluses and do not require FDI inflows - but also Brazil. We exclude Brazil because its FDI and portfolio flows data have been distorted due to disadvantageous tax treatment of portfolio flows relative to FDIs. Chart I-14 illustrates that FDIs inflows have been robust and net portfolio inflows have been negative in the past 18 months. The latter does not pass our smell test because Brazil's financial markets have rallied tremendously since early 2016. This appears simply non-credible and confirms lingering speculation that a lot of foreign capital inflows have been registered in Brazil as FDI inflows to get preferential tax treatment - and were subsequently invested in financial markets, specifically in domestic bonds, not the real economy. Chart I-13EM ex-China, Korea, Taiwan And Brazil: ##br##FDI Inflows Have Not Recovered Chart I-14Brazil: The Puzzle of FDI ##br##Inflows And Portfolio Flows Chart I-15Brazil: Strong FDI Inflows ##br##And Collapsing Capital Spending Consistently, capital spending has not recovered at all, despite the preceding collapse (Chart I-15). All in all, excluding Brazilian data, there has been little recovery in EM FDI inflows (Chart 16A and Chart I-16B). Chart I-16AFDI Inflows Into Various EM Countries Chart I-16BFDI Inflows Into Various EM Countries Bottom Line: With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. 3 Please see, "Globalisation in retreat: capital flows decline since crisis", August 21, 2017, available at https://www.ft.com/content/ade8ada8-83f6-11e7-94e2-c5b903247afd Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 Chart 2BGlobal Asset Valuations, 1990-2017 Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.
Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades