Geopolitics
I am honored to join BCA Research as Senior Vice President of the U.S. Investment Strategy service. I have been researching and writing about the economy and financial markets for more than 30 years. I joined BCA Research from LPL Financial in Boston, MA where I served as the firm’s Chief Economic Strategist. At LPL I helped to manage more than $120 billion in client assets and provided more than 14,000 financial advisors and 700+ financial institutions with insights on asset allocation, global financial markets and economics. Prior to LPL, I served in similar functions at PNC Advisors, Stone & McCarthy Research, Prudential Securities, and the Congressional Budget Office in Washington, DC. I look forward to meeting you and providing quality research in the years to come. John Canally, Senior Vice President U.S. Investment Strategy Highlights We are not changing our view on Treasury markets or our stocks over bonds call despite the news that the Fed will begin shrinking its balance sheet later this year. The Fed's action is marginally dollar positive. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. Retail sales and industrial production have accelerated, although "hard" data on business capital spending remains weak. We introduce our Bond Duration checklist this week. These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. We continue to favor U.S. equites over bonds in 2017 and recommend keeping duration short of benchmark. Despite outsized performance from high-yield corporate bonds in 2016, investors should favor stocks over high-yield over the coming year. We introduce the BCA Beige Book Monitor this week. This metric provides a quantitative look at the qualitative, or "soft" data in the Fed's Beige Book. The Beige Book is due out Wednesday, April 19. Feature Chart 1Weak Data And More Weighed ##br##On Risk Assets U.S. stocks stumbled and Treasury yields slumped last week with the 10-year Treasury yield hitting a 2017 low. The drop in yields came despite news from the FOMC that the Fed is prepared to shrink its balance sheet later this year, a bit sooner than the market expected. Comments from Fed Chair Yellen - who expressed concern that the Fed's independence is "under threat"- should have jolted the bond market, but didn't. Not yet at least. Geopolitics played a role in the week's market action as well, the main culprits being upcoming French elections, the aftermath of President Trump's missile attack on Syria and ongoing tensions in North Korea. The looming Q1 earnings reporting season weighed on risk assets as well. The dollar ended lower last week. Trump told the Wall Street Journal he prefers a weak dollar. Those comments and the tepid data helped to offset the safe-haven bid generated by the geopolitical events of the week (Chart 1). The "hard" vs "soft" data debate will continue this week and likely for some time thereafter. "Hard" data on housing and manufacturing for March as well as the U.S. leading indicator are due out this week. Of course, the ultimate set of "hard" data is the corporate earnings data. Nearly 70 S&P 500 firms will report Q1 results and provide guidance for Q2 and beyond this week. "Soft" data on the PMI, Philly Fed and Empire State manufacturing sector for April will undoubtedly keep the debate going. Our view is that the hard data will catch up with the upbeat surveys in the U.S. This week we review the key economic indicators for the major advanced economies, which highlight that the global growth acceleration remains on track. We also introduce a Duration Checklist designed to help separate "signal from noise" in the bond market. Most of the items on the Checklist remain bond-bearish. Fed plans to shrink its balance sheet is not particularly negative for bond prices, but it certainly won't be supportive. The main risk to our bond-bearish view remains geopolitics, including the first round voting and results in the French election due on Sunday, April 23. Balance Sheet Bedlam? Maybe Not The release of Minutes from the FOMC's March meeting contained a robust discussion of the Fed's balance sheet. Until recently, most market participants had assumed that the Fed would maintain the size of its balance sheet via reinvesting through at least late 2017/early 2018. The latest FOMC minutes suggest that, assuming the economy continues to track the Fed's forecast, the FOMC will allow its balance sheet to shrink this year. The FOMC will achieve this by ceasing reinvestment of both its MBS and Treasury holdings at the same time. No decision has been made about whether the reinvestments will end all at once or will be phased out over time (tapered). Chart 2 shows that when QE1 ended in 2010 and QE2 ended in 2011, U.S. equities underperformed bonds. It's important to note, however, that underperformance didn't occur in a vacuum. The European debt crisis, the U.S. rating downgrade and debt ceiling debates all weighed on risk assets after QE1 and QE2 ended. Other factors played a role as well, such as weak economic growth and policy uncertainty. Amid QE3, U.S. equities surged in 2013, returning 32.4%, while bonds fell 8.5%. But in late 2013, the Fed announced that purchases would be tapered over the course of 2014. QE3 finally ended in late 2014. Stocks and bonds battled it out over 2014 and 2015, with stocks beating bonds by 3%. Chart 2Reminder What Happened When QE1, QE2 & QE3 Ended Bottom Line: Our view remains that Fed balance sheet run-off won't have a big impact on Treasury yields, although may lead to a widening of MBS spreads. What matters more for Treasury yields than the size of the balance sheet is the expected path of short rates. As for equities, while geopolitical risks are ever-present, the U.S. economy is in far better shape today than it was when QE1, QE2 and QE3 ended. U.S. corporate earnings are pointing higher as well. While we've clearly entered a new part in the Fed cycle, the news on the Fed's balance sheet does not change our view that U.S. stocks will outperform bonds this year. All else equal, the dollar should get a small boost from a shrinking Fed balance sheet, supporting our view that the dollar will rise 10% this year. Overplaying The Soft Data And Underplaying Geopolitics...In 2018 Chart 3Global Pick-Up On Track Traders and investors have been giving up on the global reflation story of late, sending the 10-year Treasury yield down to the bottom end of this year's trading range. Missile strikes, upcoming French elections and U.S. saber rattling regarding North Korea have lifted the allure of safe havens such as government bonds. At the same time, the Fed was unwilling to revise up the 'dot plot', doubts are growing over the ability of the Trump Administration to deliver any stimulus and a few recent U.S. data releases have disappointed. It is difficult to forecast the ebb and flow of safe-haven demand for bonds, especially related to North Korea and Syria. However, our geopolitical team holds a high-conviction view that angst over Eurozone elections this year are overblown. The Italian election in 2018 is more of a threat. While we cannot rule out an even stronger safe-haven bid from developing in the coming weeks, the global cyclical economic backdrop remains negative for government bond markets. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4.7% in February on a year-over-year basis (Chart 3). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession, which was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart 4). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the three months, rising 5.2% at annual rates (Chart 5). The weak spot has been in capital goods orders (Chart 3). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near to zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart 3, third panel). Nonetheless, improving CEO sentiment, strengthening profit growth and activity surveys all suggest that capital goods orders will "catch up" in the coming months. Chart 4Manufacturing Rebound Is Not About Energy Chart 5U.S.: Non-Energy Production Surging That said, one risk to our positive capex outlook in the U.S. is that the Republicans could fail to deliver on their promises to cut taxes and boost infrastructure spending. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital expenditures. Duration Checklist: What We're Watching BCA's Global Fixed Income Strategy service recently introduced a "Duration Checklist" designed to keep us focused on the most relevant factors while trying to sift out the signal from the noise (Table 1).1 These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. Naturally, leading and coincident indicators for global growth feature prominently in the top section of the Checklist (Chart 6). All four of these indicators appear to have topped out except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past. Nonetheless, all four are still consistent with robust growth for at least the near term. Table 1Stay Bearish On Treasuries & Bunds Chart 6Some Warning From Leading Indicators The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is concerning. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The remainder of the items on the checklist are related to growth, inflation pressure, central bank stance, investor risk-taking behavior and bond market technicals. We are focusing on the U.S. and Eurozone at the moment because we believe these two economies will be the main driver of global yields over the next 12 months. In the U.S., the Fed is tightening and market expectations are overly benign on the pace of rate hikes in the coming years. Upside pressure on global yields should intensify later this year, when the ECB announces the next "tapering" of its asset purchase program. All of the economic growth, inflation pressure and risk-seeking indicators on the Checklist warrant a check mark for the U.S., although this is not the case for the Eurozone inflation indicators. From a technical perspective, the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. This removes one of the largest impediments to a renewed decline in global bond prices. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. Bottom Line: A number of political pressure points and some modest U.S. data disappointments have triggered an unwinding of short bond positions. Nonetheless, the global manufacturing revival and growth impulse remain in place, and the majority of items on our Checklist suggest that the recent bond rally represents a consolidation phase rather than a trend reversal. Keep duration short of benchmark within fixed-income portfolios. Favor Stocks Over Junk Bonds Table 2A New Trend In Junk Vs. Stocks? We continue to favor U.S. equities over bonds in 2017 and recommend keeping duration short of benchmark. But what about U.S. equities versus high-yield bonds? As a reminder, favoring corporate bonds over equities was a long-running BCA theme during the early stages of the economic recovery.We noted that corporate bonds were likely to outperform equities in a prescient Special Report published in late-2008,2 and we continued to favor corporate bonds until late-2012 when we shifted towards strong dividend-paying stocks. Table 2 highlights that our corporate bond vs equity recommendations have worked out well over the past several years. The table presents the annual total return for the S&P 500 and high-yield corporate bonds (as well as the difference between the two), and it shows that the former underperformed the latter from 2008 to 2011 (and again in 2012 in risk-adjusted terms). However, stocks materially outperformed high-yield bonds from 2013-2015, which followed our recommendation to favor the S&P Dividend Aristocrats index over corporate bonds in our November 2012 Special Report.3 But Table 2 also shows that the trend of stock outperformance reversed last year, with high-yield bonds having somewhat outpaced the S&P 500 in total return terms. Does this imply that investors are witnessing the beginning of a new uptrend in corporate bond outperformance versus equities? In our view, the answer is 'no'. Chart 7 presents our simple framework for the relative performance of stocks vs high-yield corporate bonds, which suggests that investors should favor the former over the latter. Panel 1 highlights that the trend in stocks vs high-yield is generally the same as that vs 10-year Treasuries, with a few notable exceptions of sustained difference. The first exception was from 2002 to 2004, when stocks significantly outperformed government bonds but were flat vs high-yield. The second exception occurred during the early part of this expansion, which again saw high-yield corporate bonds post equity-like returns. Chart 7Major Valuation Advantage Needed For High-Yield To Outperform Stocks Panel 2 suggests that both of these circumstances were fueled by a substantial high-yield valuation advantage over stocks. The panel illustrates the gap between the speculative-grade corporate bond yield-to-worst and the S&P 500 12-month forward earnings yield, which was elevated and fell materially in both of the cases of sustained divergence shown in panel 1. The key point for investors is that last year's outperformance of junk bonds is unlikely to continue. While the compression of the junk/stock yield gap did lead the former to outperform last year, the gap was not high to begin with and is currently not that far away from its historical lows. This suggests that there is no reason to expect the stock/junk relative performance trend to deviate from the overall stock/government bond trend, which we expect to rise further over the coming 6-12 months. Bottom Line: Despite outsized performance from high-yield corporate bonds in 2016, investors should continue to favor stocks over high-yield over the coming year (but favor both over Treasuries and cash). Introducing The BCA Beige Book Monitor Chart 8BCA Beige Book Monitor: ##br##A "Hard" Look At "Soft" Data The Fed's Beige Book is released eight times a year, two weeks ahead of each FOMC meeting. It was first released in 1983. The Beige Book's predecessor was the Red Book, first produced in 1970. The Beige Book itself got a makeover from the Fed in early 2017. The Fed changed the way the information was presented across the 12 Fed districts, but, according to the Fed, the Beige Book will continue to provide "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." In addition to the Beige Book, FOMC officials also review what is now known as the "Teal Book" at each meeting. The Teal Book combined the "Green Book" - a review of current economic and financial conditions - and the "Blue Book"- which provided context for FOMC members on monetary policy actions. As noted in the Fed's own description, the Beige Book is "soft data". In discussing the Beige Book, the financial press often notes the number of districts where growth is expanding and contracting or describes the pace of overall activity (modest, moderate etc). The BCA Beige Book Monitor takes a more quantitative approach to all the qualitative data in the Beige Book. We began by searching the document for all the words we could think of that signify strength: Strong, strength, rise, increase, accelerate, fast, expand, advance, positive, robust, optimistic, up, etc. We then counted up all the words that denote weakness: Weak, fell, slow, decelerate, decrease, decline, soft, negative, pessimistic, down, contract, etc. Next, we subtracted the number of weak words from the strong words to calculate the BCA Beige Book Monitor. The Monitor begins in 2005, so it covers the time period from the middle of the 2001-2007 expansion, through the Great Recession (2007-2009) and the recovery since 2009. A more streamlined approach, using the words "strong" and "strength" (and their derivatives like stronger, strengthened, etc) as proxy for all the strong words and the word "weak" as a proxy for all the weak words, showed the same results. We adopted this simpler approach. Chart 8, panels 1 and 2, shows the BCA Beige Book Monitor versus real GDP and CEO Confidence. The BCA Beige Book monitor does a good job explaining GDP, but it is more timely. The Monitor leads CEO confidence, especially around turning points. We intend to do more work with the Beige Book Monitor and present it to you in future editions of this publication. We also track mentions of other key words in the Beige Book. For example changes in mentions of "inflation" words in the Beige book track, and sometimes lead, core inflation (Panel 3). Mentions of the "strong dollar" track the dollar itself, although tends to be lagging (Panel 4). We'll be watching for those inflation words and mentions of the dollar in the Beige Book this week. The Beige Book will also help to shed some qualitative light on the recent weakness in capital spending and C&I loans. Has the uncertainty about the timing, scope and scale of Trump's legislative agenda (taxes, infrastructure and the repeal of Obamacare, etc) had an impact on corporate spending or borrowing? We'll find out this week. Bottom Line: Although technically it is "soft" data, the Beige Book is a major input on monetary policy decision making for the FOMC. As we showed last week, the rise in "inflation" words in the Beige Book has certainly captured the Fed's attention, and confirms the "hard" we've seen on inflation. The next FOMC meeting is on May 2-3, and neither we nor the consensus expects a hike at that meeting. Despite the apparent flare-up in geopolitics last week and the run of disappointing economic data, we continue to expect the Fed to raise rates 2 more times in 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Value And The Cycle Favor Corporate Debt Over Equities," dated November 14, 2008, available at gis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report, "The Search For Yield Continues: Aristocrats Or High Yield?" dated November 5, 2012, available at usis.bcaresearch.com
Highlights An investment's long-term attractiveness depends on the trade-off between its expected long-term return and its risk of suffering an intermediate loss. On this risk-adjusted basis: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other... ...but European equities can outperform when euro breakup risk eventually fades. Feature The English poet Samuel Taylor Coleridge coined the term "willing suspension of disbelief" in his Biographia Literaria published in 1817. It describes the sacrifice of reason and logic to believe the unbelievable. Coleridge suggested that if he could instil a "semblance of truth" into a fantastic tale, the reader would suspend judgement about the implausibility of the narrative in order to enjoy it. Today, it feels like financial market prices are relying on the willing suspension of disbelief. At our client meetings, almost everybody disbelieves that current valuations allow developed market equities to generate attractive long-term returns. Yet many investors are willing to suspend this disbelief, at least for the time being. Our own return forecasts justify the disbelief (Chart I-2). In Outlook 2017, Shifting Regimes,1 my colleague and BCA Chief Economist, Martin Barnes, published our long-term nominal return forecasts for the major asset classes. Allowing for market moves since publication, four of those 10-year annualised total returns2 now stand at: Chart I-2Valuation Drives Long-Term Returns European equities3 5.0% U.S. equities4 3.2% U.S. 10-year T-bond 2.3% Euro area 10-year sovereign bond5 1.2% With annual inflation expected at 2%, these numbers imply paltry real returns from mainstream investments over the coming decade. Still, in terms of ranking relative attractiveness, it might appear reasonable to follow the sequence of returns:6 European equities; U.S. equities; the U.S. 10-year T-bond; and then the euro area 10-year sovereign bond. But that sequence would be wrong - at least in the medium term. The key point is that the four investments are not equally risky. For a riskier asset, investors should expect today's price to generate a higher long-term return as compensation for the extra risk of intermediate loss. Put another way, a risky asset must offer a higher long-term return than a less risky asset for an investor to be indifferent between them. If it doesn't, the danger is that the price will adjust (down) at some point until it does. European Equity Valuations Must Allow For Euro Breakup Risk Consider European equities versus U.S. equities. The sovereign bond market is discounting a 5% annual risk of euro break-up (Chart I-3). This shows up as a discount on German bund yields, because in that tail-event a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. But for the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum (Chart I-4). Unfortunately, for the aggregate European stock market, the risk does not cancel out. If the euro broke up, European equities would suffer a much greater drawdown than other markets. Recall that at the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year (Chart I-5). In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30%. So assuming a 5% annual risk, European equities must compensate with a valuation discount which allows a 1.5% excess annual return over U.S. equities. Chart I-3The Bond Market Is Discounting##br## A 5% Risk Of Euro Breakup... Chart I-4...Based On The Sovereign Yield Spread##br## Between Italy And Germany Chart I-5In The Euro Crisis, The Eurostoxx ##br##Underperformed By 25% There is also the issue of the post-2016 bailout rules for European banks. At a stroke, the Bank Recovery and Resolution Directive (BRRD) has made European bank equity investment more risky. In the event of a bank failure, investors must now suffer the first losses - including full wipe-out - before governments can step in. Combining this with the risk of euro breakup, the 1.8% excess annual return that we expect from the Eurostoxx600 versus the S&P500 makes European equity valuations look fair, rather than attractive, on a relative risk-adjusted basis. That said, the good news is that if the risk of euro area breakup gradually fades, it would permit a healthy re-rating of the Eurostoxx600 versus the S&P500. For example, if the annual risk of breakup declined from 5% to 1%, it would equate to a 12% outperformance. But as the greatest political risk to the euro now emanates from Italy - and not the upcoming French Presidential Election - we recommend playing this re-rating opportunity closer to, or after, Italy's next general election.7 Equity Valuations Reliant On "Willing Suspension Of Disbelief" Now consider equities versus bonds. An expected 3.2% annual return from the S&P500 versus a 2.3% 10-year T-bond yield implies an ex-ante 10-year equity risk premium (ERP) of just 0.9% (Chart I-6). This is significantly lower than the 135-year average of 5% and even the post war average of 2.5%8 (Chart of the Week). Chart of the WeekThe Ex-Ante Equity Risk Premium Is Close To Zero Chart I-6In The U.S., The Expected 10-Year Return From Equities And Bonds Is Now Almost The Same What can justify the "willing suspension of disbelief" that permits today's abnormally low ERP? There are three arguments. All have Coleridge's "semblance of truth" but are ultimately flawed. Chart I-7In The 1970s Inflation Scare, Equities##br## Suffered Much More Than Bonds First, it is argued that the ERP should be low because bonds have become more risky. With 10-year bond yields so low, bond prices have limited upside but substantial downside. The problem with this argument is that equities are a much longer duration asset than a 10-year bond, so if inflation did take hold, equities would suffer the much greater drawdown - as they did in the 1970s (Chart I-7). Another counterargument is that bond yields have been this low on previous occasions in the past 135 years, but on those previous occasions the ex-ante ERP was not as depressed as it is today. Second, it is argued that the ERP should be low because central banks now have a tried and tested weapon - QE - which they can pull out at the slightest sign of trouble. Empirically, it might be true that QE did compress the ERP. But theoretically, it shouldn't. Even Ben Bernanke told us at our 2015 New York Conference that QE is nothing more than a signalling mechanism for interest rate policy. So it works by compressing bond yields rather than the ERP. In this sense, justifying a low ERP with QE is a worry rather than a hope. Third, and most recently, it is argued that the surprise arrival of the Trump administration is a game changer for investments - structurally positive for equities, structurally negative for bonds. The jury is out on this. But given the speed of market moves, our sense is that is the hope of fast-moving momentum traders. Slow-moving value investors are still on the side lines, waiting to see what - if anything - will really change. Mr. Market Is Little Short Of Silly In his 1949 seminal work, The Intelligent Investor Benjamin Graham, the grandfather of value investing, introduced us to a whimsical character called Mr. Market. Every day, Mr. Market quotes a price for your investments, at which you can buy or sell. Sometimes, Mr. Market's idea of value seems plausible. At other times: "Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly." The point of Graham's allegory is that investors should not cheerlead the market come what may. Mr. Market will not always quote you an attractive price; sometimes he will quote you a very unattractive price (Chart I-8). Chart I-8Mr. Market Will Not Always Quote You An Attractive Price "At which the long-term investor certainly should refrain from buying and probably would be wise to sell." Today, when we see the ugly long-term returns offered by Mr. Market and we risk-adjust for potential drawdowns, we conclude: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other, but European equities can outperform when euro breakup risk eventually fades. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 20, 2016 and available at www.bcaresearch.com 2 Nominal local currency returns including income. 3 Outlook 2017 showed "Other (non-U.S.) developed equities" but this aligns with our forecast for European equities. 4 Since Outlook 2017 was published, equity markets are up around 5%. So 10-year return forecasts have been reduced by around (5/10) = 0.5%. 5 Euro area weighted average 10-year yield weighted by sovereign issue size. 6 This assumes investors can cheaply hedge currency exposure, as is the case now. 7 Please see the Geopolitical Strategy Service Weekly Report titled "Political Risks Are Understated In 2018", dated April 12, 2017 and available at gps.bcaresearch.com 8 In this report we define the ex-ante ERP at any point in time as the Shiller P/E's implied prospective 10-year equity return (see Chart 8) less the 10-year bond yield. Fractal Trading Model* This week's trade is to go long the sugar number 11 futures contract on the NYB-ICE exchange, with a profit target of 7%. Alternatively, a more hedged position is long sugar / short aluminium with a profit target of 10%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... Chart 2... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Chart 2Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Table 2Protectionist Statements From The Trump Administration Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Chart 13Temporary Trade Barriers Ticking Up Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.
Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... Chart 2...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Global political risks are overstated, at least in 2017; Global rally in risk assets hinges on hard data, not politics; But Trump and the GOP can still pass tax reforms or cuts this year; The EU's guidelines on Brexit are benign, risks have peaked; The French presidential election remains harmless to markets. Feature Investors have a love/hate relationship with populism. On one hand, we fear what anti-establishment movements will mean for the twentieth-century institutions that have underpinned post-Cold War stability.1 On the other, markets have cheered populism and its ability to jolt policymakers out of their torpor, particularly on fiscal policy.2 This dichotomy of outcomes informs our investment theme for 2017, which holds that markets are navigating a "Fat-Tails World."3 The failure to repeal and replace the Affordable Care Act (ACA, "Obamacare") - which took us by surprise - reminded investors that President Trump will not have smooth sailing through the murky waters of congressional politics. Opposition to him has put into doubt the consensus view that populism is a political defibrillator that will shock policymakers into action. Instead of right-tail outcomes, markets are again fretting about left-tail risks: namely gridlock and obstructionism, but also protectionism, trade war, and competing nationalisms. In the long term, we are pessimists. We do not see how China and the U.S. will escape the dreaded "Thucydides Trap." We remain concerned that President Trump will grow frustrated with America's trade imbalances and strike out at friends and foes alike. But these are concerns for 2018 and beyond. In 2017, we believe that political risks remain overstated. In this weekly, we explain why. It's The Economy, Stupid! The global macro backdrop remains positive for the time being. Despite a very high global policy uncertainty index print, the market is responding to strong economic data (Chart 1), with the sum of the Citibank global economic- and inflation-surprise indexes rising to the highest level in the 14-year history of the survey.4 Chart 1Is Political Risk Overstated? Chart 2The Apex Of Globalization... Delayed? The global economic improvements are real. Chart 2 shows that PMI indexes in the developed world have reached their highest level since 2011, with global export volumes recovering from their multi-year doldrums. The Baltic dry index has gone vertical. Several other positive developments have caught our eye: Global Earnings: The global growth story has started to funnel down to company earnings, with a recovery in the net earnings-revisions ratio (Chart 3), which had been negative since 2011. Chart 3Strong Global Earnings Chart 4Godot Is Here! Return Of Capex U.S. Capex: The long-awaited capex recovery may finally be coming to the U.S., with real non-residential investment bottoming in 2016 (Chart 4). Manufacturing Renaissance: Global industrial production should have a solid year, at least judging by the strong leading economic-indicator print (Chart 5). Chart 5Industrial Renaissance Chart 6Consumers Are Elated Consumer Confidence: U.S. consumer confidence is at its highest level in 16 years (Chart 6), and should firm up from here, according to the BCA disposable-income indicator (Chart 7), and our expectation that Trump and the Republicans pass tax cuts.5 Chart 7Income Growth To Follow Chart 8Euro Area Is Doing Great European Renaissance: Data from the Euro Area remains bullish, despite the focus on political risk (Chart 8). BCA's real GDP growth models, introduced by The Bank Credit Analyst in their March report, corroborate the bullish view (Chart 9).6 Chart 9BCA's GDP Models Are Bullish The broad-based recovery in the data strongly suggest that the market's performance since the U.S. election is based on more than just a bet on Trump and his policies. Markets are responding to genuine improvements in the global economic outlook. Certainly there is something of a bet on the populists "getting it right," but hard data should continue to back up the optimism. How long can the party last? Our colleagues Martin Barnes and Peter Berezin have both recently warned of heightened recession risks in 2019.7 We are perhaps even less sanguine, observing dark clouds gathering for 2018. However, we will save that story for next week's missive. This week, we will provide our reasons for optimism about the remainder of this year. U.S.: Fade The Trumpocalypse S&P 500 fell 1.2% on March 21, the day that apparently sealed the fate of the Republicans' seven-year pledge to repeal and replace Obamacare. In our view, investors are overstating the conditional relationship between "repeal and replace" and the GOP's forthcoming tax bill. The most important political question for investors this year is simple: will the GOP blow out the budget deficit or focus on austerity? Getting the answer to this question right will go a long way in determining whether the impact on nominal GDP growth, inflation expectations, and thus the Fed's reaction-function is bullish for the S&P 500 and the U.S. dollar. This is the Trump trade: the idea that overarching reflation policy is swinging from monetary to fiscal. We still believe in Trump! That said, we acknowledge that comprehensive tax reform is tough - otherwise it would have occurred more recently than 1986.8 It is also true that the failure to repeal Obamacare will leave a few hundred billion dollars in the federal deficit that would have otherwise been available for tax cuts. Table 1 shows that the average time it takes to pass tax reform - from introduction of the bill to its signing by the president - is around five months. It is therefore not impossible, though assuredly difficult, for Congress to return from August recess this year and squeeze through a bill by Christmas Eve. TableMajor Tax Legislation And The Congressional Balance Of Power Chart 10Intra-Party GOP Polarization Falls##br## In Line With Last 80 Years Plus, Trump could always pivot away from tax reform and go after tax cuts, which are what Presidents Reagan and Bush did in 1981 and 2001. Both of these efforts took only one month to pass.9 From an economic perspective, the less ambitious option of tax cuts would be more flammable than tax reform, as it would merely increase the deficit and thus act as a more significant short-term stimulus. We see five reasons why the GOP will pass some form of tax legislation this year that will (1) add to the budget deficit, (2) lower household and probably corporate tax rates, and (3) likely include some provisions for infrastructure spending: Polarization is overstated: Intraparty ideological polarization is rising within the Republican Party, whereas it appears to be significantly declining in the Democratic Party (Chart 10).10 However, the move is not as significant as the media suggests. The average level of polarization within the GOP is well within the range of the past century. In fact, the GOP remains considerably less polarized than the Democrats were for most of the post-Second World War era. The data therefore suggests that while the GOP is indeed becoming more conservative (Chart 11), it is doing so uniformly. The measurable differences between the "Tea Party," represented in the House of Representatives by the Freedom Caucus, and the rest of the party are overstated. Chart 11Polarization Increasing Between, Not Within, The Two Parties Trump still has political capital: Despite a slump in national opinion polls, the president retains support among Republican voters (Chart 12). This means that he can threaten to campaign against Freedom Caucus representatives in the 2018 mid-term elections, as he did recently in an ominous tweet.11 Data suggest that voters would indeed follow Trump and dump the Freedom Caucus. Trump is very popular among Tea Party voters, even in Texas when put up against the state's Tea Party champion Senator Ted Cruz (Chart 13). Given that voter turnout in primary races in a mid-term election is below 10% for Republicans, a series of Trump rallies in Freedom Caucus districts could be sufficient to change the course of the election. Chart 12Republican Voters Support Trump Chart 13Trump Is A Threat To The Tea Party Chart 14Budget Deficits: Not As Hot Of A Priority Budget deficits are less relevant: Given the first two points, why did the Freedom Caucus oppose President Trump on health care? Because Obamacare and its replacement were both "big government programs," whereas these are "small government" Republicans. It was not because Freedom Caucus constituencies are laser-focused on lowering budget deficits! In fact, 22% fewer Republicans see reducing the budget deficit as the top policy priority as did in 2012, when the Tea Party was in full stride (Chart 14). Tax cuts are popular among Republican voters. Expanded budget deficits can be sold to them as a way to "starve the beast" of government.12 Institutional constraints to reform are overstated: "God put the Republican Party on earth to cut taxes." The famous quip from Washington Post columnist Robert Novak is a good guide for investors on tax reform. Many of our colleagues and clients tend to over-complicate their political analysis. Opposing tax reform and/or cuts will be political suicide for Republican legislators. And if budget deficits grow too much, the GOP can rely on two time-tested strategies to find "offsets" for tax cuts: Revenue Offsets: Republicans still have a handful of possibilities to raise revenues to offset the loss from cuts in tax rates even if they abandon the border adjustment tax (which they have not yet done). First, they can require companies to repatriate their offshore earnings, whose taxes are deferred. Second, they could engage in limited reform by closing some loopholes in the tax code. Third, they could let certain "tax extenders" expire at the end of the year as they are technically scheduled to do. Fourth, they could reduce the size of the tax cuts from the very ambitious plans outlined in their now outdated 2016 proposals. These decisions would be politically difficult, but that does not mean that all of them will fail. Crucially, the leader of the Freedom Caucus, Representative Mark Meadows (R-N.C.), now claims he would support tax cuts that are not fully offset by revenues. The Freedom Caucus appears to have expended most of its political capital on opposing the Obamacare replacement and is now tucking its tail between its legs! Dynamic Scoring: Republicans have emphasized macroeconomic feedback, i.e. the fact that tax cuts generate growth, which in turn generates tax revenues, defraying the initial revenue losses of the cuts. The Republicans will argue that static accounting methods make tax cuts seem more costly than they will be in reality. For instance, while it is true that President Bush's White House vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 15). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 16). Chart 15Bush Was Right, ##br##CBO Was Wrong! Chart 16Dynamic Scoring Will Offset About##br## 10% Of Revenues Lost To Tax Cuts Timing is flexible: The GOP have the option of making tax cuts retroactive and thus avoiding a huge market disappointment if tax cuts come later in the year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.13 Chart 17Republicans Are Not Deficit-Neutral Our high-conviction view remains that tax reform - or less ambitious tax cuts - is still coming this year. It is empirically false that Republicans care more about balancing the budget than about reducing the tax burden on individuals and corporates (Chart 17). Arguments to the contrary rely on the time-tested (and failed) analytical strategy of "this time is different." Of course, the timing and legislative process lack clarity (Diagram 1). Republicans still plan to use "budget reconciliation" to sneak through tax reform or cuts. This allows them to approve tax policy with a simple majority, i.e. to bypass any "points of order" or filibusters in the Senate that would raise the bar to a 60-vote supermajority. The rules of reconciliation require a bill to be deficit-neutral beyond the five- or ten-year window mapped out in Congress's preceding budget resolution (the latter, for FY2018, has not yet passed). But this means that a bill that blows out the budget deficit can still be passed as long as it has a "sunset clause" at the end of the 10-year period, as was the case with President Bush's tax cuts.14 We are also sanguine on the more immediate question of government funding. Congress has to agree to fund the government by April 28 - the expiration date of December's continuing resolution - in order to avoid a government shutdown. Democrats are threatening to sink the appropriations bills (or omnibus bill) if Republicans attach noxious "riders" to it, such as defunding Planned Parenthood or building Trump's border wall. We think the Democrats are bluffing. Furthermore, leading Republicans are already signaling that they will postpone their moves on the most toxic issues to avoid a shutdown that would make them look incompetent. Diagram 1U.S. Congressional Budget Timeline 2017 What about the upcoming vote to confirm President Trump's pick for the Supreme Court, Judge Neil M. Gorsuch? Is there any investment relevance of the pick? We do not think so. Judge Gorsuch will replace Judge Antonin Scalia and thereby protect the slightly conservative tilt of the court. Investors should watch to see if enough Democrats in fact filibuster the nomination and if Republicans change Senate rules to override filibusters for Supreme Court nominations (the so-called "nuclear option"). If Democrats insist on goading Republicans into this rule change, then the odds of bipartisan compromise on legislative initiatives (such as an infrastructure package) will fall, relative to a situation where some Democrats endorse Gorsuch and Republicans uphold Senate norms. Bottom Line: The market no longer believes that corporate tax reform will happen. High tax-rate companies have given back all of their post-election equity gains (Chart 18). We think this selloff is a mistake. As our report this week attests, we base our view on a study of political, legislative, and constitutional constraints to tax reforms and cuts. We are highly skeptical of "this time is different" narratives that overstate the power of the Freedom Caucus. As a direct bet on our high conviction view, we recommend that investors go long the high tax-rate basket relative to the S&P 500. Chart 18How To Profit From Tax Reform Chart 19Brexit Political Risk Bottomed In January Brexit: Much Ado About Nothing? The market has ignored both the invocation of Article 50 by London on March 29 and the publication of the EU's negotiation "guidelines" on March 31.15 As we discussed in January, political tensions between the EU and the U.K. likely peaked before January 16. This was the day when the market fully priced in the rumors that the U.K. would seek to withdraw from the EU Common Market. Prime Minister Theresa May confirmed the rumors on January 17 with a key speech. We have been long the GBP since.16 Investors continue to fret that there are more risks to come, but the market agrees with our assessment. The GBP bottomed against the EUR on October 11 (just after the Conservative Party conference where PM May affirmed the government's commitment to the referendum result) and bottomed against the USD on January 16. It has rallied against both currencies since the latter date (Chart 19). Why? First, the EU guidelines on the Brexit negotiations do not appear to be aggressive. The EU has offered the U.K. a "transition period," for an indefinite time between the U.K.'s technical withdrawal (March 29, 2019) and the new cross-channel status quo (for example, a free trade agreement, FTA). This is significant given that financial media doubted whether any transitional deal would be on offer as recently as a week ago. Second, the EU has implied that it will at least begin talks on an FTA with the U.K. while the negotiations on withdrawal are still ongoing. This is not exactly what London asked for but it is close.17 This means that the EU will hold the U.K.'s liabilities to the bloc for ransom before it begins negotiating a post-membership deal, but it also means that the EU does not want to threaten a "status cliff" where the U.K. and EU fail to forge any deal and hence revert back to basic WTO tariffs. Third, a leaked copy of an EU parliamentary resolution on Brexit also suggests that a "transition period," in this case limited to three years, is in the offing.18 It also hints at what we have long argued, that the EU would treat the U.K.'s notice of withdrawal (triggering Article 50) as revocable, i.e. reversible. That said, some negatives are obvious from both documents: The EU parliamentary resolution insists that the City of London does not get special access to the EU's common market; Spain will get a veto on whether the final agreement applies to the territory of Gibraltar; The U.K. will have to settle its financial commitments to the EU; No "cherry picking" of common-market benefits will be allowed. These points do not surprise us. We have been pessimists on London's ability to retain access to the EU common market well before Brexit. And May's own speech on January 17 cited that London would not seek to "cherry pick" benefits from the common market. Our assessment remains that the EU is not out for blood. Or, as we put it in our January 25 note: Now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. May's January 17 speech was therefore a classic "sell the rumor, buy the news" moment. Of course, we expect further risks and crises, especially with the British press laser-focused on the issue. But much of the hysterics will be irrelevant. Take the issue of the dreaded "exit fee." The media has focused on the fee as if the EU is seeking to impose a blood tax on the U.K. Instead, the roughly €60 billion "fee" is merely the remaining portion of U.K.'s contribution to the 2014-2020 EU budget, plus other liabilities. The EU sets its budgets on a seven-year horizon and the U.K. is going to remain a member state until March 2019. Some British newspapers think that the U.K. can continue to live in an EU apartment for the remainder of its lease without paying rent! The fact of the matter is that the EU is a trading power focused on expanding its markets. It is not in the interest of core member states, especially the export-oriented powerhouses such as Germany, Sweden, and the Netherlands, to lose the U.K. as a trading partner. And it is certainly not in their interest to impose such painful retribution as to risk harming their own economies. What about the message that the EU would want to send to other member states? This is only important if the likelihood of exit by another EU member state is high. As we discussed immediately after the referendum, the risks of EU dissolution are grossly overstated.19 Recent elections in Austria and the Netherlands confirm our analysis, and we expect that French elections will as well. Yes, Italy is a risk to the EU, given that Euroskepticism is on the rise there. However, the EU has ample tools with which to dissuade the Italians from exiting - starting with a market riot that the ECB can induce at any time by reversing its offer to buy Italian debt. And it is doubtful that the EU can change Italian sentiment through punitive Brexit negotiations. What kind of a post-Brexit relationship should investors expect between the U.K. and the EU? There are three options: Customs union: The U.K. is not likely to accept a Turkish arrangement in which it belongs to the customs union but not the common market. That is because the customs union forces Turkey to apply the common EU tariff on all imports, while its exports do not benefit from other countries' trade deals with the EU. The U.K. wants more autonomy over trade, so this is unlikely to be the solution. The Turkish deal also excludes trade in services, which the U.K. will want to promote. Common market lite: The U.K. has a low-probability option of accepting the Norwegian or Swiss options of membership in the common market despite non-membership in the customs union. These options would allow only a few limits to the EU's demand of free movement of goods, services, people, and capital; they are currently non-starters because the U.K. is prioritizing curbs on immigration. It is possible that the U.K. could come around to something similar later, but it would require a shift in domestic politics, of which there is little evidence yet. Chart 20British Public Remains Divided On Brexit FTA: The U.K. is more likely to have an FTA arrangement, comparable to the just-signed EU deal with Canada. This would give the U.K. more autonomy on trade deals with third parties, while keeping tariffs to a minimum and incurring no obligation of free movement of people. It would also likely be more robust than the Canadian deal because of the much higher level of existing integration. Still, the U.K.'s prized service sector would suffer, as FTAs rarely cover services adequately. In fact, one of London's long-standing problems with the EU itself was lack of implementation of the 2006 EU Services Directive, which was supposed to harmonize trade in services and reduce non-tariff barriers to trade. We place the probability of the U.K. reverting back to WTO rules on trade with the EU - the most adverse scenario - to zero. Why such a high-conviction view? The EU has a customs agreement with Turkey, a country that threatens Europe with a Biblical exodus of refugees once every fortnight. In comparison, the U.K. and the EU are geopolitical allies that cooperate on national security, foreign policy, climate change, and other issues. There is no way that investors will wake up in 2019 and find that the U.K. has a worse trade agreement with the EU than Turkey.20 It is not all smooth sailing for the U.K., however. Brexit is not an optimal outcome for the U.K. economy.21 Leaving the EU means a deep cut in its labor-force growth rate, service exports, and inward FDI flows, reducing the U.K.'s growth potential. That said, given that the transitional deal will likely extend the horizon of "final Brexit" to around 2022 - or even beyond - and that there is still a small chance of a total reversal of Brexit, it is very difficult to predict the final impact on the U.K. economy now. There is another option that investors should consider. With Scottish independence gaining steam,22 and political risks rising in Northern Ireland, perhaps the EU is trying to kill Brexit with kindness. Polls on the Brexit referendum remain tight (Chart 20), which suggests that the "Remain" camp could eventually regain the upper hand - particularly if the shock to household income from inflation persists (Chart 21). With the U.K.'s own union at risk, perhaps the Tory leadership will alter its exit strategy over the course of negotiations. Meanwhile, investors should remember that: Chart 21Bremain May Regain Popularity ##br##When Brexit Bites Chart 22British Public Not Divided On ##br##Current Leadership Article 50 is almost certainly revocable. This is a political issue, not a legal one, as we have long stressed, and as the EU parliament leak suggests. Theresa May has promised that the final deal with the EU will be put to a vote in parliament. The bearish view has assumed that a failure of the vote would cast the U.K. into the abyss of no trade relationship other than the WTO's general agreement on tariffs. But failure could also follow from a shift in politics in the U.K. that seeks to act on the revocability of Article 50 and rejoin the EU. We see no sign of such a shift at the moment (Chart 22), but two to five years is time enough for one to develop. The next U.K. election will take place by May 2020, unless the government engineers a special early election. That is only a year after Article 50's two-year withdrawal period ends. If political winds are changing direction, the EU's allowance of a transition period could widen the window for a relatively smooth reverse-Brexit. In other words, "Brexit still means Brexit," but there are various escape hatches if the public demurs. The Scottish referendum has put a new constraint on the Tories and the EU may have figured out that the best way to encourage the Brits to change their mind is to smother them with kindness. What indications would suggest that the U.K. is changing strategies or the EU turning aggressive? In the U.K., a move to hold early elections could suggest that Prime Minister May wants a mandate of her own. This could enable her to pursue her current strategy more resolutely, but it could also give her the flexibility to reverse it. A sudden loss of support for the Tories, or a surge in the polling in favor of "Bremain," could also trigger a change in the government's approach. A significant public concession by the government in the negotiations could also mark a pivot point. In the EU, the following actions would suggest that the Brexit strategy will become less benign (and that our sanguine view is wrong): stonewalling in the exit negotiations, a reversal of the "Barroso doctrine" in order to encourage Scottish independence, a decision to shorten or deny the transition period, a lack of seriousness in trade negotiations, a downgrading of security and defense relations, or a move to pry away Gibraltar, among others. Bottom Line: We maintain our view that the pound bottomed along with the political risk on January 16. Yes, Brexit is not an optimal outcome, but the EU appears to be willing to push off the final date of the break with the U.K. into the future. At some point, we expect the U.K.'s inward FDI to suffer as companies - especially banks - grapple with the reality of Brexit. However, given the negotiations and potential transitional deal of up to three years, that date could be anywhere from two to five years into the future. Update On France: Can We Worry Now? We have spent much ink this year explaining why populist Marine Le Pen is not going to win the two-round French election on April 23 and May 7.23 Polls continue to support our view, with Le Pen trailing Emmanuel Macron by 26% with 33 days to go to their likely second-round matchup (Chart 23). At this point in the U.S. election, candidate Trump trailed Secretary Hillary Clinton by only 5%. Even Francois Fillon appears to be rallying against Le Pen. Despite ongoing corruption allegations against him, Fillon is leading Le Pen in a hypothetical second-round matchup by 16%. Chart 23Le Pen Lags Both Her Rivals##br## In Key Second Round Chart 24Is American Midwest A Path To##br## Le Pen Presidency? Chart 25No Comparison Between ##br##Le Pen And Trump A sophisticated New York client challenged our comparison of Trump's national polling against Clinton to that of Le Pen and her rivals. Instead, the client asked us to focus on the massive underperformance of the polls in the Midwest, where Trump surprised to the upside and beat long odds to win in Pennsylvania, Michigan, and Wisconsin (Chart 24). We agree that it is all about voter turnout, but again the numbers bear out Le Pen's weakness. She would have to perform six times better than Trump did in the Midwest to win the election (Chart 25). Chart 26Italy's Euroskeptics Much ##br##Stronger Than France's Chart 27The Market Is Missing ##br##The Italian Risks Chart 28Long French Bonds, Short Italian We are not dogmatic on the subject, we just refuse to agree with the lazy conventional wisdom that "polls are wrong." They are not. National polls got the U.S. election almost perfectly (the polls predicted a 3.2% Clinton victory and she won the popular vote by 2.1%). It is not our problem that pundits overestimated Clinton's strength, especially in the rustbelt states. Our own quantitative model gave Trump a 40% chance of winning the election on the night of the vote, roughly double the consensus view.24 We will therefore upgrade Le Pen's chances of winning when she starts making serious improvement in her second-round, head-to-head polling. Meanwhile, in Italy, the establishment continues to lose support to Euroskeptic parties (Chart 26). The media have not caught on to this risk, perhaps because they are feasting on negative news from France (Chart 27). The bond market has begun to price higher risks in Italy, with spreads between French and Italian bonds having risen 76 bps since January 2016 (Chart 28). However, they remain 296 bps away from their highs in 2012. We suspect that Italian bonds will see further underperformance relative to French bonds. Bottom Line: We continue to monitor risks in France due to the presidential elections. However, Le Pen remains behind both of her likely opponents by double digits in the second round. We remain long French industrial equities relative to their German counterparts as a play on expected structural reforms post-election. In addition, we are initiating a long French bonds / short Italian bonds recommendation due to our fear that Italy is the one and only risk to European integration in the short and medium term. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Investment Strategy Special Report, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. 6 Please see The Bank Credit Analyst, "March 2017," dated February 23, 2017, available at bca.bcaresearch.com. 7 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com. 10 Data for polarization analysis uses "nominate" (nominal three-step estimation), a multidimensional scaling method developed to analyze preference and choice. Researchers use the bulk of roll call voting in the U.S. Congress over its entire history. Our Chart 10 measures intra-party polarization along the "primary dimension," which is the liberal-conservative spectrum on the basic role of the government in the economy. 11 "The Freedom Caucus will hurt the entire Republican agenda if they don't get on the team, & fast. We must fight them, & Dems, in 2018!" @realDonaldTrump 12 The quote "starve the beast" is a proverbial phrase that has applied to taxes at least since the 1970s. Nowadays it refers to cutting taxes and revenue in an effort to force cuts in expenditures. While the quote is attributed to President Ronald Reagan, he never used it. Instead, he used the analogy of a child's allowance during his campaign in 1980: "If you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker." Subsequent Republican administrations have used similar rhetoric to justify tax cuts, including that of George W. Bush. 13 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and courts upheld the legislation. Hence there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 14 Please see Megan S. Lynch, "The Budget Reconciliation Process: Timing Of Legislative Action," Congressional Research Service, October 24, 2013, available at digital.library.unt.edu, and Tax Policy Center, "What Is Reconciliation," Briefing Book, available at www.taxpolicycenter.org. See also David Reich and Richard Kogan, "Introduction to Budget 'Reconciliation,'" Center on Budget and Policy Priorities, November 9, 2016, available at www.cbpp.org. 15 Please see Council of the European Union, "Draft guidelines following the United Kingdom's notification under Article 50 TEU," dated March 31, 2017, available at bbc.co.uk. 16 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 17 The exact wording from the EU guidelines: "While an agreement on a future relationship between the Union and the United Kingdom as such can only be concluded once the United Kingdom has become a third country, Article 50 TEU requires to take account of the framework for its future relationship with the Union in the arrangements for withdrawal. To this end, an overall understanding on the framework for the future relationship could be identified during a second phase of the negotiations under Article 50. The Union and its Member States stand ready to engage in preliminary and preparatory discussions to this end in the context of negotiations under Article 50 TEU, as soon as sufficient progress has been made in the first phase towards reaching a satisfactory agreement on the arrangements for an orderly withdrawal." 18 Please see Daniel Boffey, "First EU response to article 50 takes tough line on transitional deal," The Guardian, March 29, 2017, available at www.theguardian.com. 19 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 20 No way. 21 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, Special Report, "The French Revolution," dated February 3, 2017, Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com.
Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Chart 5Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Chart 11Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Chart 32The Contribution To Growth From Rising Human Capital Is Falling Chart 33Math Skills Around The World Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades