Financial Markets
Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Chart 7...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Chart 12...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Chart 8Sovereigns Still##br## Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The dollar rally is set to continue. The dollar tends to perform best when real rates are rising and above r-star. We are entering this environment and raising our DXY target to 98. Moreover, the rest of the world is likely to be more vulnerable to higher U.S. rates than the U.S. itself. Not only does the Federal Reserve set the cost of capital for the world, debt excesses are more prevalent outside the U.S. than in it. Additionally, the U.S. is less impacted by slowing global industrial activity than the rest of the world. Relative growth dynamics will therefore flatter the greenback. Italy is weighing on the euro, and any deterioration in the pricing of Italian risk will further hurt the common currency. However, EUR/USD does not even need Italian drama to depreciate. Relative growth and inflation are enough to push the euro toward 1.12. Feature The beginning of the year was a tough time for the dollar, with the DXY plunging nearly 4% from January 1 to February 15th. However, soon after Valentine's day, the market became enamored with the greenback, prompting the USD to rally a hefty 6%. Now that the dollar has hit our target of 94, it is time to pause and ask a simple question: can the U.S. currency rally further, or is it time to bail on the rally? While we do think the secular trend for the greenback is down, we also believe the current rebound has further to run. We are revising our DXY price target to 98. Essentially, we are entering a window where both U.S. monetary policy and the global growth backdrop will give the dollar an additional boost. The Over And Under On R-Star Table I-1Fed And The Dollar: Where We Stand ##br##Matters As Much As The Direction A common market lore is that the dollar tends to appreciate in anticipation of rising rates, but once the Fed actually begins to increase rates, the dollar weakens. There is some truth to this assertion. The 1994 and 2004 experiences do bear these facts. Moreover, the DXY fell 8.5% after the ill-fated December 2015 hike, and fell more than 11% as the Fed hiked rates through 2017. However, these kinds of simple heuristics can be deceiving. Where we stand in the hiking process matters just as much. In other words, it is not only whether interest rates are rising that counts, but whether or not they are rising above the neutral rate, or r-star. This distinction makes all the difference. As Table I-1 illustrates, the heuristic holds true when the Fed begins lifting rates but the real fed funds rate is below r-star. In this environment, the average annual return of the DXY since 1973 has been -5%, and the dollar has generated negative returns 75% of the time. However, the picture changes drastically if the real fed funds rate rests above the r-star. In this environment, the DXY rises alongside the fed funds rate, generating average annual gains of 4.7% 70% of the time. These results have been robust, independent of what was expected in interest rates futures. When the fed funds rate is falling, it is difficult to generate any strong views, as neither the expected returns nor the batting averages are statistically different from the expected outcomes of coin tosses. Chart I-1We Are Entering The Dollar-Bullish##br## Part Of The Fed Cycle Interwoven behind this picture is global growth. We have long argued that global growth is a key determinant for the dollar: When it is strong, the dollar weakens; when it is weak, the dollar strengthens.1 Essentially, when the fed funds rate rises but is still below r-star, global growth is improving, often even more so than U.S. growth, leading to a soggy greenback. When the fed funds rate moves above r-star, we tend to see hiccups around the world, essentially because the global cost of capital starts to rise, hurting the most vulnerable places. This helps the dollar. Sometimes, the most vulnerable country to higher U.S. interest rates happens to be the U.S., in which case the dollar does not respond positively to rising rates, even if they are above r-star. This is exactly what happened between 2005 and 2006. Today, we are entering an environment where the dollar is likely to receive a fillip from the Fed. As Chart I-1 illustrates, the real fed funds rate is about to punch above the Laubach-Williams estimate for r-star. It is true that the LW measure for r-star is only an estimate of this crucial but unobservable concept, and that it is subject to revisions, but the Fed is set to increase rates at least four times over the next 12 months, which in our view will definitely push the fed funds rate above realistic estimates of r-star. As a result, we should anticipate the dollar to rally further. Bottom Line: When we think about the Fed and the dollar, rising interest rates are not enough to boost the greenback. Actually, if U.S. real rates rise but are still below the neutral rate of interest, this generally results in very poor dollar performance, like what transpired in 2017 and the first month of 2018. If, however, the fed funds rate is both rising and above the neutral rate, the dollar rallies. We are entering this environment. Why Is This Time NOT Different? If one were to make the argument that the dollar will not rally as the fed funds rate moves above the neutral rate - which has happened in 30% of past occurrences - one needs to make the case that the U.S. is more vulnerable to higher U.S. rates than the rest of the world. We do not want to make this bet. First, there does not seem to be any obvious imbalances in the U.S. economy right now. Historically, periods of vulnerability in the U.S. have been preceded by an elevated share of cyclical sectors as a percentage of GDP. This was particularly obvious last cycle, when cyclical sectors represented 28% of GDP in 2006, and residential investment was particularly out of norm, at almost 7% of GDP (Chart I-2). Today, cyclical sectors represent 24.3% of GDP, in line with the average of 25.4% since 1960. Moreover, while there are rampant fears that the U.S. current account deficit will blow up, at the moment - thanks to decreasing oil imports - it only stands at -2.5% of GDP, much narrower than the levels that prevailed in 2006 (Chart I-3). Second, the key ingredient that would generate vulnerability in the U.S. is not present, but it is visible around the world: too fast a pace of debt accumulation. Not only do debt buildups make financial systems and economies illiquid, if the accretion is built swiftly it raises the probability of a misallocation of capital. After all, investing is a time-consuming activity, and if done too quickly chances are that due diligence was not very diligent. Today, it is true that there has been a deterioration in the quality of the corporate sector debt in the U.S., but nonetheless, the U.S. private sector has curtailed its debt load, and has been rather reluctant to re-lever. In the rest of the G-10, debt loads are as elevated as ever, and in fact are hitting record highs in Canada, Australia, and the Scandinavian economies. In EM and China, not only are debt levels elevated, they have also been rising briskly (Chart I-4). The vulnerabilities are therefore outside the U.S. and not in the U.S Chart I-2No Cyclical Imbalances In The U.S. Chart I-3Better External Balance As Well Chart I-4Debt: U.S. Robust, RoW Not So Much Third, global growth is facing an important headwind emanating from China. The Chinese economy has been in the process of slowing, and continues to do so: Leading the charge have been efforts by Chinese policymakers to diminish the pace of debt accumulation. As Chart I-5 illustrates, not only has the Chinese credit impulse rolled over, but the decline in working capital of small financial intuitions suggests that more pain is in the pipeline. Real estate activity is slowing down. The prices of newly built units in the main cities are contracting on an annual basis, and in second-tier cities price appreciation is slowing. As a result, construction activity is also downshifting. The growth of industrial profits has slowed considerably, hitting a 14-month low. Railway traffic, electricity production and excavator sales are all decelerating sharply. The Li-Keqiang index is also slowing and, according to our leading index based on credit activity, is set to continue to do so (Chart I-6). Unsurprisingly, Chinese import growth is also slowing significantly, implying that China is not providing as much of a shot in the arm for the rest of the world as it did 12 months ago (Chart I-6, bottom panel). Chart I-5Chinese Policy Tightening In Action Chart I-6The China Syndrome EM economies are particularly exposed to these dynamics. As we like to put it when we talk to our clients, if EM economies were a security, Chinese activity would drive cash flow growth, while U.S. monetary policy dictates the cost of capital. This is especially true today, as a record amount of EM-ex-China exports go to China, while USD-debt as a percentage of EM GDP, reserves and exports is at multi-decade highs (Chart I-7). This analogy suggests that EM economies are therefore the most vulnerable corner of the world to higher U.S. rates: Not only is their indebtedness high, but they are also facing a potent headwind from China. Hence, we expect EM financial conditions to deteriorate further, with negative implications for EM growth. However, EM have been the most dynamic contributor to global growth and global trade. This implies that if EM growth conditions deteriorate, so will global trade and global industrial activity (Chart I-8). As we have highlighted before, the U.S. is normally insulated from these dynamics as commodity production, manufacturing and exports represent a relatively low share of gross value added in what is fundamentally a domestically driven economy. Through this aperture, the relative resilience of the U.S. to the recent decline in global growth is unsurprising. To the contrary, we can expect this current bout of growth divergence to stay in place for much of 2018 (Chart I-9). Chart I-7EM Have A Lot Of Dollar Debt Chart I-8Weak EM Equals Weak Global IP Chart I-9Global Growth Divergences As a result, global growth dynamics are likely to buttress the bullish implications for the dollar of a Fed lifting rates above r-star. As Chart I-10 shows, slowing global growth is good for the dollar. This is likely to be especially true this time around as investors have yet to purge their overhang of short-dollar bets (Chart I-11). Moreover, as we highlighted five months ago, from a stylistic perspective, the dollar is the epitome of momentum currencies within the G-10.2 The indicator that has empirically best captured the momentum-continuation behavior of the dollar is the gap between the 1-month moving average and the 6-month moving average. Currently, this indicator is flashing an unabashedly bullish signal for the USD (Chart I-12). Chart I-10The Dollar Is A Countercyclical Currency Chart I-11Still Short The Dollar Chart I-12Momentum Currrently Favors The Dollar Bottom Line: This time will not be different, and the dollar should rise as the Fed pushes interest rates above r-star. The U.S. private sector has not experienced any material debt buildup in recent years, and is less vulnerable to higher rates than emerging markets. Since the U.S. is less sensitive to EM growth than other advanced economies, the U.S. is relatively insulated from any EM slowdown, explaining why the U.S. economy is not slowing like the rest of the world is right now. This is a positive backdrop for the dollar. Euro Weakness: More Than Just Italy The euro's weakness through the recent dollar rally has been particularly striking. Recent developments in Italy have supercharged this weakness, as investors are once again questioning the commitment of Italy to staying in the euro area - an assessment that is weighing on Italian assets (Chart I-13). However, Marko Papic argues in BCA's Geopolitical Strategy service that Italy is not on the verge of leaving the euro area.3 However, the Five-Star movement / Lega Nord coalition wants to challenge the EU's Stability and Growth Pact 3% limit on budget deficits. As Dhaval Joshi argues in BCA's European Investment Strategy service, Italy has a fiscal multiplier greater than one, and thus more spending is likely to help the Italian economy over the coming year - whether or not the now-infamous issuance of mini-BOTs are involved.4 And to be honest, the Italian economy needs all the help it can get (Chart I-14). Chart I-13Markets Are Worried About Italy Chart I-14Italian Economy Has Yet To Heal However, it remains to be seen how much Italy will be able to open the fiscal spigot. Much depends on the willingness of the bond market to finance this intended profligacy. So far, the move in Italian BTPs has been small, but any repeat of 2010-2012 will prevent the coalition government from implementing its desired spending plans. Such a confrontation between the bond market and Italian politicians could cause a sharp decline in the euro. To be clear, it is highly unlikely that the coalition will be able to increase the deficit by the EUR100bn planned in its manifesto. To note, Rob Robis has downgraded Italian bonds to underweight in BCA's Global Fixed Income Strategy service.5 While Italian risks have exacerbated the weakness in the euro, ultimately the weakness in the common currency simply reflects the greater shock to European growth resulting from a slowing China. As Chart I-15 illustrates, European growth tends to underperform U.S. growth when Chinese monetary conditions are tightened, or when China's marginal propensity to consume - as approximated by the growth rate of M1 relative to M2 - declines. We are currently facing this environment. Chart I-15AChina's Deceleration Is Filtering Into Europe (I) Chart I-15BChina's Deceleration Is Filtering Into Europe (II) In addition, not only is European growth falling behind the U.S., but the European economy is also feeling the pinch from the tightening in financial conditions vis-à-vis the U.S. that ensued following the furious euro rally of 2017. In response to these combined shocks, European core inflation is now weakening relative to the U.S., which normally portends to a weakening euro over the course of the subsequent six months (Chart I-16). Since investors have yet to clear their massive long bets on the euro, we think the euro will need to flirt again with fair value before being able to stage a durable rally (Chart I-17). While the euro's fair value is currently 1.12, we will re-evaluate the situation once EUR/USD moves below 1.15. Despite the upbeat picture we have painted for the dollar, the greenback still faces potent structural headwinds, which means that we cannot be too careful and need to approach any dollar rebound with a great deal of care, always keeping an eye open for potential risks to the dollar. Chart I-16Relative Inflation And The Euro Chart I-17More Downside In EUR For Now Bottom Line: Italian political developments are currently hurting the euro. The euro will suffer further if the bond market ends up rioting, unwilling to finance the coalition's deficit-busting proposals. While such dynamics would precipitate a sharp and violent fall in the euro, EUR/USD does not need Italian misadventures to weaken further. The euro continues to trade at a premium to its fair value, and the euro area is feeling the pain of a slowing China deeper than the U.S. is. Therefore, European growth and inflation are likely to weigh further on the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "More Than Just Trade Wars", dated April 6 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "Some Goods News (Trade), Some Bad News (Italy)", dated May 23, 2018, available at gps.bcaresearch.com 4 Please see European Investment Strategy Special Report, titled "Italy Vs Brussels: Who's Right?", dated May 24, 2018, available at eis.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report, titled "Is It Partly Sunny Or Mostly Cloudy?", dated May 22, 2018, available at gfis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to perform well with the Manufacturing and Services PMI coming in at 56.6 and 55.7, respectively, beating expectations. However, the dovish Fed minutes were the highlight of this week. While inflation seems to finally be making a comeback, members of the FOMC opined that it was "premature to conclude that inflation would remain at level around 2 percent". This implies a higher possibility of the Fed's pursuit towards a more "symmetric" inflation target, indicating that the Fed doesn't want to raise rates more aggressively than what is implied it the current dot forecasts. The 2-year yield fell by 7.1 bps, while the 10-year fell by 6.9 bps on the news. Furthermore, the Fed has become increasingly cautious in its communications in the face of a flattening yield curve. Despite these potential negatives, the dollar continues to appreciate as global growth softens. This rally could run further as European and EM data continues to disappoint. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Is King Dollar Facing Regicide? - April 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 This week was negative across the board for the euro area. French, German and overall euro area Manufacturing, Services and Composite PMIs all underperformed expectations. In addition to lackluster economic data, the eurosceptic M5S-Lega coalition is now putting the Brussels to the test. As expected, the BTP-Bund spread spiked to just below 2%, near levels that last prevailed in early 2017, and the euro has been suffering as a result of this. While the ECB's QE program is scheduled to end in September, the current situation is a threat and may necessitate a lower euro to ease monetary conditions. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: The Nikkei Manufacturing PMI came in below expectations, coming in at 52.5. This measure also decreased from last month's reading. Annualized gross domestic product growth for Qtk surprised to the downside, coming at -0.6%. Moreover, machinery orders yearly growth also surprised negatively, coming in at -2.4%. After rising by more than 2% the last couple weeks, USD/JPY has come back below 110 recently. We believe that the yen will most likely be amongst the best performing G-10 currencies, given that an environment of declining global growth and rising risk normally supports the yen. However, on a longer term basis, the yen is likely to see downside, given that the BoJ will not allow an appreciating yen from derailing the economy. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Headline and core inflation both surprised to the downside, coming in at 2.4% and 2.1% respectively. They also both decreased from last month's number. Industrial Production yearly growth also underperformed expectations, coming in at 2.9%. Finally, Halifax house price yearly growth also surprised negatively, coming in at 2.2%. GBP/USD has gone down by nearly 1.5% these past few weeks, dragged down by the euro's weakness. Overall, we remain bearish on cable, given that inflation should continue to surprise to the downside in the U.K, as a result of the appreciation of the pound last year. On the other hand inflation in the U.S. should outperform, as a result of the decreased excess capacity and tight labor market. This will force the Fed to raise rates more than the BoE, putting downward pressure on the pound. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data has been mixed recently: Westpac Consumer Confidence was negative in May, at -0.6%; The Wage Price Index annual growth remain unchanged at 2.1%, also in line with expectations; The unemployment rate picked up to 5.6% from 5.5%, however, the participation rate also increased by 0.1% to 65.6%; Employment grew by 22,600, with full-time employment at 32,700 and part-time contracting by 10,000; Governor Lowe spoke in Sydney this week at the Australia-China Relations Institute, citing Australia increased dependence on the second largest economy in the world, and the "bumpy" journey along the path of financial reform that China is likely to experience. This is likely to bring increased volatility to an Australian economy already replete with excess capacity. The RBA is unlikely to raise interest rates any time soon. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Both exports and imports surprised to the upside, coming in at 5.05 billion and 4.79 billion respectively. Additionally, the trade balance also outperformed expectations, coming in at -3.78 billion dollars. Finally, the Producer Input Price Index quarterly growth also surprised positively, coming in at 0.6%. The kiwi has declined by more than 1.5% this past weeks. Overall we continue to be bearish on NZD/USD, given that we expect the current environment of heightened volatility to persist. That being said, we are bullish on the NZD against the AUD, as Australia is much more exposed to a slowdown in the Chinese industrial cycle and as the Australian economy exhibits more signs of slack than New Zealand's. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar has managed to remain flat despite the recent broad-based selloff of commodity currencies against the greenback. Canada's inflation has been in line with the BoC's target. Furthermore, a resilient labor market and robust wage growth point to favorable domestic demand conditions and greater inflationary pressures in the coming quarters. External factors such as a favorable oil market, relative to metals, have helped the CAD against other commodity currencies, despite this week's weakness. Going forward, these variables are likely to continue to support the loonie against the likes of the Aussie or the Kiwi. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: The Producer Price index underperformed expectations, coming in at 2.7%. Moreover, headline CPI inflation also underperformed expectations, coming in at 0.8%. EUR/CHF has declined by almost 2% these past weeks. We continue to be bearish on this cross, given that an environment of continued risk aversion should hurt the euro, while giving a boost to safe heavens like the franc. Italy's political tumult only adds credence to this argument. However, on a long term basis we are positive on EUR/CHF, given that the SNB will maintain an extremely easy monetary policy, much more so than the ECB, in order to prevent an appreciating franc which would derail its objective of ever reviving inflation in Switzerland. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline CPI inflation outperformed expectation, coming in at 2.4%. Meanwhile, core CPI inflation came in line with expectations, at 1.3%. USD/NOK has been relatively flat in the month of May. Overall rising U.S. real rates relative to Norway should lift USD/NOK, even amid rising oil prices. That being said, the krone is likely to outperform other commodity currencies like the AUD or the NZD. This is because oil is less sensitive to China than other commodities, and the black gold is supported by a friendlier supply backdrop, especially as tensions in the Middle East are once again rising and Venezuela is circling down the drain. NOK should continue to appreciate against the EUR as well. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 While Swedish producer prices annual growth picked up to 4.9% from 4% in April - suggesting a resurgence in inflationary pressures, labor market conditions softened as the unemployment rate climbed to 6.8% from 6.5%. The Riksbank also released a commentary on household debt, citing a "poorly functioning housing market" and a "tax system not being well designed from a financial stability perspective" as reasons for the current predicament. There was also emphasis placed on the uncertainty of house prices going forward. While these factors are present, resurgent inflation will ultimately prompt the Riksbank to hike, albeit cautiously, in order to avoid having to raise rates too violently down the road, which could cause serious harm to a Swedish economy afflicted by considerable internal imbalances. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights China's industrial sector will continue decelerating, while consumer spending is so far booming. The world economy in general and EM in particular are exposed much more to China's industrial sector than to its consumer spending. The U.S. dollar will continue strengthening, regardless of the trend in U.S. bond yields. The reason is slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. Stay put on / underweight EM financial markets. Turkey will need to hike interest rates more before a buying opportunity in its financial markets emerges. Feature The two key elements affecting the performance of EM financial markets are the U.S. dollar and commodities prices. The combination of a weak U.S. dollar and higher commodities prices is typically bullish for EM. The opposite also holds true: A strong dollar and lower commodities prices are bearish for EM. But what about the recent dynamics - the rally in the greenback and strong commodities prices? This combination is unlikely to be sustained. Historically, the divergence between the dollar's exchange rate and commodities prices has never lasted long (Chart I-1). The fundamental linkage between the U.S. dollar and commodities prices is global growth: improving global growth is positive for resource prices, and the U.S. currency has historically been negatively correlated with global trade - the trade-weighted dollar is shown inverted in this chart (Chart I-2). Chart I-1Commodities And The Dollar Chart I-2Global Growth And The Dollar Hence, if global growth stays strong, the U.S. dollar will pare its recent gains and commodities prices will stay well-bid. Conversely, if global trade decelerates commodities prices will inevitably have to change direction. We expect the dollar to stay well-bid because the current phase of dollar rally will at some point be followed by a second phase where the greenback's strength is driven by a slowdown in global trade. In this phase, commodities prices and U.S. bond yields will drop alongside a strengthening U.S. dollar. Weaker growth in China and in other EMs is the key reason we expect global trade volumes to slow. Is China Slowing? Making sense of growth conditions in China is never easy, but it is particularly confusing these days. We maintain that there is growing evidence that China's industrial segment is slowing and will continue doing so, yet consumer spending is still booming. The basis for the industrial slowdown is a deceleration in both money and credit growth, which has been taking place over the past 18 months or so. With respect to households, the borrowing binge continues. The unrelenting 20%+ annual growth in household credit continues to fuel the property bubble. In turn, a rising wealth effect from real estate as well as decent income growth are the underpinnings behind the booming consumer sector. The main and relevant point for investors from the perspective of China's impact on broader EM is as follows: the drop in the credit and fiscal impulse is heralding a deceleration in capital expenditures/construction. That, in turn, will lead to fewer imports of commodities and materials. Imports are the main transmission mechanism from China's economy to the rest of the world. Mainland imports in RMB terms have indeed decelerated meaningfully, yet import values in U.S. dollar terms have not (Chart I-3). So, what explains the recent gap between imports in yuan and dollar terms? The RMB's rally versus the U.S. dollar in the past 15 months has been responsible for this gap between import values. As one would expect, the spending power of mainland industrial companies has moderated because less credit and fiscal expenditures are being injected into the system (Chart I-4). Yet because the RMB now buys 10% more U.S. dollars than it did a year ago, mainland buyers' purchasing power of foreign goods that are priced in dollars has improved. As a result, the pace of growth of the value of U.S. dollar imports has remained buoyant. Chart I-3Chinese Imports In RMB & USD Terms Chart I-4Weaker Purchasing Power ##br##In China Will Hurt Imports If the RMB's exchange rate versus the dollar remains flat over the next 12 months, the growth rates of both imports in RMB and dollar terms will converge. In this case, a further slowdown in import spending in RMB terms will translate into considerable deceleration in mainland imports in U.S. dollar terms. In brief, the exchange rate is important because the U.S. dollar's depreciation versus the RMB since January 2017 has prevented the spillover from a slowdown in China's imports in local currency terms to the rest of the world in general and EM in particular. Chart I-5Goods And Services Imports: China And U.S. If and as the dollar continues to rally versus the majority of currencies, China could allow its currency to slip versus the greenback to assure a flat trade-weighted exchange rate and preserve its competitiveness. In such a scenario, China's purchasing power of goods and services from the rest of world will be impaired - which in turn means this economy will be remitting fewer dollars to the rest of the world. This will reduce the flow of U.S. dollars from China to EMs, adversely impacting the latter's financial markets and economies. Chart I-5 illustrates that China's imports of goods and services amount to $2.3 trillion compared with U.S. imports of goods and services of $3.1 trillion. Therefore, in terms of importance in global imports, China is not too far behind America. This holds true with respect to remitting dollars to the rest of the world. Provided that China imports more from EM - both from Asian manufacturing economies and commodities producers - than the U.S. does, then less mainland imports will entail fewer dollars flowing to EM. In short, the continued slowdown in China's purchasing power in U.S. dollar terms will negatively affect the rest of EM. This rests on our baseline view that mainland credit growth will continue slowing and the RMB will weaken against the dollar, albeit modestly for now. Mirroring the divergence between industrial sectors and consumers in the Middle Kingdom, there has been an equally clear divergence within imports: Imports of industrial supplies excluding machinery have slumped, while imports of household goods have continued to flourish. Chart I-6 demonstrates that imports have decelerated for base metals, chemicals, wood, mineral products and rubber. Even oil and petroleum products imports have slowed (Chart I-7). Yet imports of consumer goods are roaring (Chart I-8). Chart I-6China: Industrial Imports Are Slowing Chart I-7Chinese Fuel Imports Are Slowing Chart I-8Chinese Consumer Goods Imports Are Robust Which one is more important for EM: the industrial sector or consumer spending? Many developing economies in Latin America, Africa, the Middle East as well as countries such as Russia, Indonesia and Malaysia are very dependent on their commodities exports. These economies do not benefit much from booming Chinese consumers. For them, the critical variable is the mainland's industrial sector and its absorption of minerals and resources. In terms of size, Table I-1 illustrates that non-food commodities, industrial goods, machinery, equipment and transportation make up overwhelming majority of China's total imports. Meanwhile, consumer goods imports, excluding autos, comprise 15% of total imports. Hence, their impact on the rest of the world is small. Table I-1Structure Of Chinese Imports Further, most of consumer goods that households in China consume are produced locally rather than imported. That is why the world economy at large and EM in particular are more exposed to the mainland's industrial sector than its consumer one. Aside from imports, there are several other variables that validate our thesis of an ongoing slowdown in China's industrial sector. In particular: Total floor space sold (residential plus non-residential) has rolled over, heralding weakness in floor space started and, eventually, construction activity (Chart I-9). Growth rates of total freight traffic, diesel consumption, electricity and plate glass output have slumped (Chart I-10). Chart I-9Slowdown In Chinese Real Estate Chart I-10China: Industrial Economy Is Weakening Nominal manufacturing production is decelerating in response to a weaker broad money impulse (Chart I-11). The Komatsu Komtrax index - which measures average hours of machine use per unit of construction equipment (excluding mining equipment) - has begun contracting (Chart I-12). Chart I-11China: Downside Risks In Manufacturing Chart I-12China: Sign Of Construction Slump Even though China's spending on tech products has been vibrant, the global semiconductor cycle - a harbinger of overall tech industry growth - is clearly downshifting as evidenced by declining semiconductor prices (Chart I-13). Finally, narrow money (M1) growth has historically correlated with Chinese H-share prices, and is currently pointing to considerable downside risk for Chinese equity prices (Chart I-14). Chart I-13Semiconductor Prices Are Falling Chart I-14Chinese Share Prices Are At Risk Bottom Line: China's industrial sector has been decelerating, a trend that will persist. Meanwhile, consumer spending is so far booming. The former is more important to the rest of the world in general and EM in particular than the latter. EM Selloff: Two Phases While it is impossible to forecast the timing and character of market dynamics and mini-cycles with precision, our assessment is that two phases of an EM selloff are likely. Phase 1: A relapse in EM financial markets occurs on the back of rising U.S. bond yields, a strong dollar, amid resilient commodities prices. This phase is currently underway. Phase 2: U.S. bond yields peter out and drift lower, yet the U.S. dollar continues to firm up, commodities prices relapse and the EM selloff progresses. This stage has not yet commenced. The driving force behind these dynamics would be slower global demand growth emanating from China and spreading to other developing countries. In between Phases 1 and 2, it is possible that EM will stage a temporary rebound. Yet the duration and magnitude of such a rebound are impossible to gauge. Because of its transient nature, barring precise timing, the rebound will be very difficult to play profitably. It is not impossible to envision that the escalating turmoil in EM financial markets could at some point lead the Federal Reserve to sound less hawkish. That could mark a top in U.S. bond yields. In such a scenario, will a peak in U.S. bond yields mark a bottom in EM currencies? It may do so temporarily, but the sustainability of a rally in EM currencies and risk assets would be contingent on global growth in general and commodities prices in particular. Chart I-15An Unsustainable Rebound ##br##In EM Stocks In 2014 As a matter of fact, a similar two-phase selloff with a rebound in between occurred in 2013-'15. Chart I-15 illustrates that EM currencies and stocks staged a short-lived rebound after U.S. bond yields peaked in late 2013. Yet this rally proved transient. The underlying impetus behind the resumption in the EM downtrend back in 2014-'15 was weakening growth in China, falling commodities prices and poor domestic fundamentals. Similar to the 2013-'15 episode, any rebound in EM risk assets resulting from lower U.S. bond yields will likely be fleeting if commodities prices drop, the dollar continues to firm up and global growth disappoints. To sum up, a potential rollover in U.S. bond yields in the coming months will not automatically entail an ultimate bottom in EM risk assets. Trends in global growth - particularly in China - and commodities prices will be critical to the outlook for EM. As per our themes and discussion above, we maintain that China's industrial growth and construction will surprise on the downside. Consequently, China's commodities imports will moderate, which will weigh on commodities prices. In the interim, weak global trade dynamics stemming from EM/China will benefit the dollar, which is a countercyclical currency. Bottom Line: The U.S. dollar will continue strengthening regardless of the trend in U.S. bond yields because of slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. EM financial markets will remain under selling pressure as long as global growth continues slowing. EM Foreign Funding Vulnerability Ranking Which countries are most exposed to lower foreign funding? Chart I-16 presents ranking of EM countries based on foreign funding requirements. The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-16Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. Mostly, these stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen. The basis for this is depreciating currencies will make their foreign debt liabilities more expensive to service. Besides, as these debtors allocate more resources to service foreign debt, their spending will be negatively impacted and their domestic economies will weaken. Investment Conclusions Chart I-17Downside Risks In EM Share prices The dollar's strength will be lasting. Stay short a basket of select currencies such as the BRL, TRY, ZAR, CLP, IDR, KRW and MYR versus the U.S. dollar. For portfolios that need to overweight some EM currencies relative to the rest, our favorites are MXN, RUB, PLN, CZK, TWD, THB and SGD. CNY will for now modestly weaken versus the dollar but outperform many other EM peers. The biggest risk to the U.S. dollar in our opinion is the Trump administration's preference for a weaker greenback. Therefore, "open-mouth" operations by the U.S. administration to weaken the dollar are possible, and the dollar could experience temporary setbacks. Yet the path of least resistance for the dollar remains up, for now. There is considerable downside in EM share prices. Stay put and underweight EM versus DM in general and the S&P 500 in particular. Chart I-17 illustrates that rising EM sovereign bond yields and U.S. corporate bond yields (both shown inverted on the chart) herald a further selloff in EM stocks. Our equity overweights are Taiwan, Korea, Thailand, India, central Europe, Chile and Mexico, and our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. For fixed-income investors, defensive positioning is warranted. As EM currencies continue to depreciate, sovereign and corporate credit spreads will widen further. Credit portfolios should continue underweighting EM sovereign and corporate credit relative U.S./DM corporate credit. Foreign holdings of EM local currency bonds remain massive. EM currency depreciation versus DM currencies will erode returns for foreign investors and could spur some bond selling, exerting upward pressure on local yields as well.1 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Is The Worst Over? After having dropped 30% in U.S. dollar terms since their peak in late January, Turkish equity prices are beginning to look depressed, begging the question whether a buying opportunity is in the cards. Our assessment is as follows: the nation's financial markets are not yet at the point to warrant an upgrade (Chart II-1). Judgment on Turkish markets is contingent on three questions: Has the lira become cheap? Are real interest rates sufficiently high to depress domestic demand and reduce inflationary pressures? Are equity valuations cheap enough to warrant buying despite the poor cyclical profit outlook? First, the lira needs to get cheaper. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of May 23 the lira is one standard deviations below its historical mean (Chart II-2). For it to reach one-and-half or two standard deviations below its fair value, it would roughly take another 10%-20% depreciation, versus an equal-weighted basket of the dollar and euro. Chart II-1Turkish Financial Markets ##br##Have More Downside Chart II-2The Turkish Lira Is Not That Cheap Second, in regard to monetary policy, our view is that it would take an increase of around 200-250bps in the policy rate in addition to yesterday's hike of 300bps to stabilize financial markets. Core inflation will likely rise to at least 14-15% from the current level of 12% in response to the ongoing currency depreciation. With the effective policy rate (the late liquidity window rate) now at 16.5%, another 200-250 basis points hike would push the nominal rates to 18.5-19% and real policy rate to 3.5-4%, a minimum level that is likely required to depress excessive domestic demand growth. Finally, equity valuations are reasonably appealing but not cheap enough to put a floor under share prices given the outlook for contracting corporate and bank profits. Chart II-3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now about 6, compared with the historical average of 8. Although this bourse is already one standard deviation cheap, the outlook for profit recession likely warrants even lower valuation to justify buying. Chart II-3Turkish Equities Could Get Cheaper An approximate 20% drop in share prices in local currency terms will bring the CAPE to 4.8, one-and-half standard deviation below the fair value. On the whole, an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms will likely create a buying opportunity in Turkish financial markets. That said, it is doubtful whether there is the political will - to tolerate another 15% drop in the currency from current levels or more tightening in monetary conditions in the very near run ahead of the upcoming June parliamentary elections. Given the authorities' tolerance for higher borrowing costs is low, investors should not rule out the potential for capital controls to be imposed. In fact, to protect assets against possible capital control, we would recommend investors who are short to consider booking profits if the exchange rate surpasses 5 USDTRY in a rapid manner. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD Non-dedicated long-only investors should for now stay clear of Turkish financial markets. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we continue recommending underweight positions in Turkey. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 We discussed EM currencies and bonds in details in May 10, 2018; the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Stable global demand; steady declines in Venezuela's crude oil output; and the cumulative loss of 500k b/d of Iranian exports to U.S. sanctions by 2H19 will lift average Brent and WTI prices to $80 and $72/bbl in 2019, respectively (Chart of the Week). Brent prices will average $78/bbl in 2H18, while WTI goes to $72/bbl, as these supply-side effects are not material to prices this year. We lowered our estimate of Venezuela output to 1.2mm b/d by end-2018 (vs. 1.3mm b/d previously), and to 1.0mm b/d by end-2019 (vs. 1.2mm b/d). Offsetting these losses and continued deterioration in non-Gulf OPEC supply in 2019, we assume OPEC 2.0 slowly restores 1.2mm b/d in 1H19, and U.S. shale oil grows 1.4mm b/d. Even so, balances tighten significantly (Chart 2).1 Chart of the WeekBrent Will Average $80/bbl In 2019 Chart 2Balances Tighter As Supply Falls If Venezuela collapses, and its ~ 1mm b/d of crude exports are lost, Brent crude oil could go to $100/bbl by end 2019, in the simulation we ran assuming exports collapse in 2H18. Uncertainty over supply and demand responses to higher prices makes this difficult to model. Highlights Energy: Overweight. Our options recommendations - long Brent call spreads spanning Dec/18 to Aug/19 delivery - are up an average 50.5%. Our long S&P GSCI position, recommended Dec 7/17 to take advantage of increasing backwardation, is up 18.9%.2 Base Metals: Neutral. Copper rallied earlier this week on an apparent easing of trade tensions between the U.S. and China. However, a statement by U.S. President Trump suggesting uncertain progress in talks led to a reversal in most of these gains by mid-day Wednesday. Precious Metals: Neutral. Our long gold portfolio hedge and tactical long silver position were relatively flat over the past week, as the broad trade-weighted USD moved higher. Ags/Softs: Underweight. China's Sinograin, the state grain buyer, reportedly was in the market this week showing interest in purchasing U.S. soybeans, according to agriculture.com's Successful Farming website. Feature Barring the immediate collapse of Venezuela's oil industry and the loss of its ~ 1mm b/d of oil exports, which we discuss below beginning on page 7, the global crude market will continue to tighten from the supply side, on the back of ratcheting geopolitical pressures. Chief among these are the continuing loss of Venezuelan crude oil production, which, even without a total collapse that wipes out its ~ 1mm b/d of exports, will see production fall to 1.2mm b/d by the end of this year from ~ 1.44mm b/d at present. This represents a decline in our previous estimate of 100k b/d. By the end of 2019, we expect Venezuela production to fall to 1.0mm b/d, 200k b/d below our previous estimate. One year ago, Venezuela was producing just under 2.0mm b/d of crude. The other supply source affected by geopolitics is Iran, where we expect export volumes to fall later this year, due to the re-imposition of U.S. nuclear-related sanctions (Chart 3). We are modeling a loss of 200k b/d by year-end 2018, and a cumulative loss of 500k b/d by the end of 1H19.3 Lastly, we have raised the probability OPEC 2.0 keeps its production cuts in place in 2H18 to 100% from 80%. This added $2/bbl to our 2018 Brent forecast. We expect a wider Brent - WTI differential this year, and left our 2018 WTI forecast at $70/bbl. Chart 3Iran Exports Down 500k b/d By 2H19, In BCA Model The steady decline in Venezuelan production and the loss of Iranian exports, coupled with an extension of OPEC 2.0's production cuts to end-2018, will take total OPEC crude oil production to 32.0mm b/d this year (down 300k b/d y/y), and 31.7mm b/d next year. Non-Gulf OPEC production also falls: coming in at 7.5mm b/d this year, these producers account for a 300k b/d y/y loss, and, at 7.0mm b/d next year, a 500k b/d y/y loss in 2019. Once again this leaves non-OPEC production as the leading source of new supply: We have total non-OPEC liquids (crude, condensates and other liquids) up 2.12mm b/d to 60.7mm b/d this year, and up 2.11mm b/d next year. This is led - no surprise - by U.S. shales, which we expect to increase by 1.3mm b/d this year to 6.52mm b/d, and 1.5mm b/d next year to 7.98mm b/d, respectively (Chart 4). Net, we expect global crude and liquids supply to average 99.73mm b/d this year, and 101.76mm b/d in 2019. On the demand side, our growth estimates are unchanged in our latest balances model. We continue to expect global demand growth of 1.7mm b/d this year and next - the prospects of which strengthened with an apparent dialing back of U.S. - China trade animosities over the past week (Chart 5). This will move the level of global consumption up to 100.3mm b/d this year and 102mm b/d next year, as can be seen in Table 1. Chart 4Steady Decline In Venezuela Exports,##BR##Iran Sanctions Tighten Markets Chart 5Global Demand Remains Strong In##BR##Our Updated Balances Models The effect of the supply-side adjustments to our model - holding our demand assumptions pretty much constant - can be seen in the new path of OECD inventories vis-à-vis the 2010 - 2014 five-year average level of stocks (Chart 6). OPEC 2.0's strong compliance with its production-management agreement, along with losses of Venezuelan and Iranian exports and above-average demand growth caused estimated OECD commercial inventories to fall ~ 303mm bbls versus Jan/17 levels. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 6Tighter Markets, Lower Inventories,##BR##Keep Forward Curves Backwardated Keeping OECD inventories below their 2010 - 2014 average levels means Brent and WTI forward curves will remain backwardated at least to the end of 2019, which, we believe, is OPEC 2.0's ultimate goal. This will ensure the coalition's member states receive the highest price along these forward curves, while the coalition's U.S. shale-oil rivals are forced to hedge at a lower price a year or two forward. Backwardation also works to the advantage of commodity index investors, particularly when the investable index is heavily weighted to oil and refined products like the S&P GSCI.4 This recommendation is up 18.9% since it was recommended Dec 7/17. Net, we expect Brent prices to average $78/bbl in 2H18, while WTI goes to $72/bbl. For next year, we expect Brent to average $80/bbl and WTI to average $72/bbl. Simulation Of A Venezuela Supply Shock To Oil Markets The likelihood Venezuela manages to maintain exports of ~ 1mm b/d this year and next falls daily.5 Were markets to lose these export volumes, they initially would scramble to replace them, leading to a short-term price spike, in our view. We simulated the loss of Venezuela's ~ 1mm b/d of exports, assuming these volumes fall off in June, and starting, in Jul/18, OPEC 2.0 gradually restores the 1.2mm b/d it actually cut from production over 2H18. By Jan/19 OPEC 2.0's 1.2mm b/d cuts are fully restored, in our simulation. However, the loss of Venezuela exports is only fully realized in 2H19, assuming oil consumption stays strong. Brent prices end 2019 ~ $100/bbl (Chart 7). OECD inventories fall to ~ 2.65 billion bbls by end 2018, and to ~ 2.32 billion bbls by end-2019 (Chart 8). This is not unreasonable, given the inelasticity of demand to price over the short term, but we would expect that in 1H20, demand would fall in response to higher prices. Chart 7Oil Prices Move Higher In Our Simulation,##BR##If Venezuela's Exports Collapse... Chart 8... OECD Inventories Drop Sharply,##BR##As Well Of course, by that time, the supply side likely would have adjusted as well. We will be exploring this further and developing additional simulations to understand the evolution of prices beyond 2020. How this plays out is unknowable at present. But, as a starting point for understanding the implications of losing Venezuela's exports, this is a reasonable set of assumptions, given the challenges in not only returning OPEC 2.0 volumes removed from the market, but getting them to refining centers in 2H18. What is unclear at present is how governments will use their strategic petroleum reserves (SPRs), and whether OPEC will fire up spare capacity to handle the loss of Venezuela's exports, should this occur. Much will depend on how OPEC 2.0 and consumer governments' SPRs interact if exports collapse. Production Cuts, Inventories, SPRs And Spare Capacity In the simulation above, we reckon OPEC 2.0 flowing production can be brought back to market in fairly short order, and that still-ample inventories and spare capacity would be available to cover the sudden loss of Venezuela's exports, to say nothing of strategic petroleum reserves held in the U.S., China, Japan, and the EU. The key, though, is how long it would take to get this supply to market, and how governments holding SPRs react. We estimate it will take anywhere from one to three months to begin to restore the volumes OPEC 2.0 took off the market if Venezuela goes offline. It will take a few months for the restored crude production to start flowing into pipelines and on to ships, followed by 50- to 60-day journeys from the Gulf to be delivered to refining centers. Chart 9OPEC Spare Capacity ~ 2% Of Global Supply,##BR##Lower Than 2003 - 2008 Price Run-Up In the meantime, refiners would continue to draw crude inventory to supply product markets, along with product inventories, a critical consideration going into the northern hemisphere's summer driving season. In a short-term pinch, governments could draw their strategic petroleum reserves to fill the gaps while OPEC 2.0 production is being restored, and markets get back to the status-quo ante prevailing prior to the loss of Venezuela's exports.6 OPEC's ~ 1.9mm b/d of spare capacity - most of which is located in KSA - could be called upon in an emergency; however, this requires 30 days to be brought on line, per U.S. EIA, and can only be sustained for at least 90 days (Chart 9). The EIA is forecasting OPEC spare capacity will fall from current levels of 1.9mm bbls to ~ 1.3mm bbls by end-2019.7 Given these uncertainties, we continue to recommend investors remain long Brent crude oil option call spreads, which we recommended over the course of the past few months.8 We expect prices and volatility to move higher, both of which are positive for option positions. Bottom Line: Venezuela's crude oil production is in free-fall. We estimate it will drop to 1.2mm b/d by the end of this year, and to 1.0mm b/d by the end of next year. Iran's exports could fall 500k b/d by the end of 1H19, as a result of the re-imposition of nuclear sanctions by the U.S. These geopolitically induced supply losses tighten markets in 2019, raising our prices forecasts for Brent and WTI to $80 and $72/bbl, respectively. We are raising our Brent forecast for 2018 by $2/bbl, expecting prices to average $76 and $70/bbl, respectively, since these risks likely do not kick in until late in 2018. A collapse in Venezuelan production could spike prices to $100/bbl by the end of 2019, even as OPEC 2.0 restores the 1.2mm b/d of production it removed from markets beginning in 2H18. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its production cuts of ~ 1.2mm b/d and natural declines have removed ~ 1.8mm b/d from the market. 2 Backwardation is a term of art used in commodity markets to describe an inverted forward price curve - i.e., prompt-delivery commodities trade higher than the same commodity delivered in the future. The opposite of backwardation is contango. 3 There is an extremely high degree of uncertainty around this estimate, which is why we are treating it as our Bayesian prior, and will be revising it as additional information becomes available. We do not believe all of the production restored by Iran post-sanctions - 1mm b/d - will be lost to export markets, but starting with a prior of ~ half of it being lost due to less-than-full re-imposition of sanctions is reasonable. 4 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes from buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. Roll yield can be illustrated by way of a simplistic example: Assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Matters have only gotten worse since the Council on Foreign Relations published its so-called Contingency Planning Memorandum No. 33 February 13, 2018, titled "A Venezuelan Refugee Crisis," which opened with the following: Venezuela is in an economic free fall. As a result of government-led mismanagement and corruption, the currency value is plummeting, prices are hyperinflated, and gross domestic product (GDP) has fallen by over a third in the last five years. In an economy that produces little except oil, the government has cut imports by over 75 percent, choosing to use its hard currency to service the roughly $140 billion in debt and other obligations. These economic choices have led to a humanitarian crisis. Basic food and medicines for Venezuela's approximately thirty million citizens are increasingly scarce, and the devastation of the health-care system has spurred outbreaks of treatable diseases and rising death rates. The CFR's memo is available at https://www.cfr.org/report/venezuelan-refugee-crisis 6 There is no way to model exactly how this will play out, absent a detailed plan put forward by the IEA and China, where the largest SPRs reside. IEA members have bound themselves to hold reserves equal to 90 days of net petroleum imports. Among the largest SPRs, U.S. holds just over 660mm barrels of oil in its SPR; China held ~ 290mm barrels at the end of last year, based on IEA estimates. Germany and Japan together hold close to 550mm bbls, according to the Joint Organizations Data Initiatives (JODI). KSA's crude oil inventories - not exactly SPRs - stood at ~ 235mm barrels in March, according to JODI. We are highly confident disposition of these reserves in the event of a shock to Venezuela's exports is being discussed in Washington, Paris, Riyadh and Beijing. Please see p. 2 of the U.S. Government Accountability Office's Testimony Before the subcommittee on Energy, Committee on Energy and Commerce, House of Representatives, "Strategic Petroleum Reserve, Preliminary Observations on the Emergency Oil Stockpile," released for publication Nov. 2, 2017. 7 This actually is a fairly low level of spare capacity, amounting to ~ 2% of global supply. During, the price run-up of 2003 - 2008, OPEC's total spare capacity was near or below 3% of supply and that was considered tight at the time. 8 Please see p. 11 for a summary of these trades' performance. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
As with all bull markets, the question on investors' minds has never been if it would end but when it will end as the former is a certainty and the latter is the source of alpha. We have previously noted that by almost all measures, this is the longest bull market in history and, with its age starting to show, it is time to focus on late-cycle dynamics. With that in mind, we have examined the relationships between the peak of the ISM manufacturing composite index, the peak of the S&P 500 and the beginning of the recession. Our cycle-on-cycle analysis is presented below and yields an important insight: Typically, the S&P 500 falls modestly after the ISM peaks but then delivers one last hurrah, before the end of the cycle, yielding the fattest returns of the bull market. We have overlaid this cycle-on-cycle chart with the S&P 500, indexed to 0 at the most recent ISM peak in March of this year, underlining our thesis that, despite being past the peak of the ISM, the S&P 500 has not yet seen its best days. Please see this week's Special Report for more details, including an analysis of the durations of each phase of the late cycle as well as sector winners & losers as the cycle draws to a close.