Developed Countries

Special Report

Highlights Corporate Default Rate: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. Corporate Bond Valuation: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy: Corporate spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth. However, tighter Fed policy and a higher-than-expected corporate default rate could pressure spreads wider in the second half of 2019. We will be quick to back off our overweight corporate bond stance when our near-term spread targets are met. Feature Investors should remain overweight corporate bonds within U.S. fixed income portfolios, but be conscious that the window for outperformance may close quickly. While the Fed’s dovish turn and signs of global growth stabilization will allow spreads to tighten during the next few months, corporate default risk is rising in the background. This week’s report focuses on corporate default risk. We assess where the default rate is headed during the next 12 months and discuss the implications for investment strategy. Default Rate Near A Bottom Chart 1 shows that the trailing 12-month speculative grade default rate has been steadily falling since early 2017. However, it also shows that the fair value reading from our macro-driven default rate model has not fallen as much. The actual trailing 12-month default rate came in at 2.7% in February, the fair value reading from our model stands at a loftier 3.6%. Chart 1Corporate Default Rate Near A Bottom? Our default rate model is based on two factors, Commercial & Industrial bank lending standards and gross corporate leverage. The latter is defined as total nonfinancial corporate debt divided by pre-tax profits. With that in mind, our model provides a framework for assessing where the default rate is headed under different scenarios for corporate profit and debt growth. We consider each of these two factors in turn. Corporate Profit Growth Will Moderate Nonfinancial corporate pre-tax profits grew an astonishing 17% during the four quarters ending in Q3 2018, but all leading indicators point to deceleration in Q4 2018 and beyond. On the revenue side of the ledger, leading indicators are in universal agreement that growth is poised to slow (Chart 2): Chart 2Corporate Revenues Will Soften The ISM Manufacturing index has fallen to 54.2 from a recent peak above 60. The year-over-year growth rate in total business sales came in at 2% in December, down from a recent peak of 8.4%. The year-over-year growth rate in industrial production fell to 3.5% in February, from a September peak of 5.7%. The year-over-year growth rate in the U.S. Leading Economic Indicator is down to 3.2% as of January, from a September peak of 6.8%. Clearly, the global growth slowdown has migrated to the U.S. and the impact is being seen in the leading U.S. economic data. Some slowdown in corporate revenue growth is all but assured. All leading indicators point to deceleration in corporate profit growth in Q4 2018 and beyond. Corporate profit growth and investment spending are tightly linked in the sense that firms are more likely to take on new projects when they feel better about their future cash flow prospects. The upshot is that we can infer trends in corporate profits by looking at data on investment spending and firms’ investment plans. That data paint a similar picture of widespread deceleration (Chart 3): Chart 3Investment Indicators The year-over-year growth rate in core durable goods orders is down to 4% from a recent peak close to 9%. An average of firms’ capital spending plans as reported in regional Fed surveys remains elevated, but has declined markedly in recent months. Small business capital spending plans, as reported to the NFIB, have fallen sharply during the past few months. Periods of tightening lending standards coincide with decelerating corporate debt. Wage growth is another important driver of corporate profits. In particular, we can get a read on profit growth by looking at the difference between corporate selling prices and unit labor costs, aka our Profit Margin Proxy (Chart 4). Our Profit Margin Proxy remains at a high level because growth in unit labor costs has been tepid. Even though top-line wage growth has improved, this has been matched by an acceleration in productivity growth (Chart 4, bottom panel). The latter has kept unit labor costs low, even as nominal wages have risen. Chart 4Wage Growth A Drag On Profits Extremely tight labor markets will lead to a continued acceleration in wage growth during the next few quarters.1 Meanwhile, the prospect for continued rapid productivity growth is much more uncertain. It seems reasonable to expect that corporate profits will come under some downward pressure from rising unit labor costs during 2019. Finally, we can get a sense of the corporate profit outlook by looking at equity analyst net earnings revisions (Chart 5). Analyst earnings per share (EPS) upgrades outpaced downgrades for most of 2018, but that trend reversed sharply near the end of last year. Analysts are once again lowering EPS forecasts more often than they are raising them. Chart 5More EPS Downgrades Than Updgrades Debt Growth Should Also Slow Fortunately, some of the balance sheet impact from decelerating profits will likely be offset by slower debt growth during the next few quarters. Corporate debt growth has been robust and fairly stable since 2012, but C&I lending standards tightened slightly in the fourth quarter of last year. Typically, periods of tightening lending standards coincide with decelerating corporate debt (Chart 6). Chart 6Tighter Lending Standards Implies Slower Debt Growth Anecdotally, several high profile firms have recently taken steps to curtail debt growth. Most notably, General Electric just announced a major asset divestment to pay down debt, and the stock market rewarded them for doing so. If our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. More broadly, we observe that firms with low debt/asset ratios have been outperforming firms with high debt/asset ratios, a dynamic that tends to occur when lending standards are tightening and corporate debt growth is falling (Chart 7). Chart 7Low Leverage Firms Are Outperforming For a sense of scale, nonfinancial corporate debt grew 6.5% in the four quarters ending Q4 2018 and has averaged 6.3% since 2012. Some mild deceleration from these growth rates is likely during the next few quarters. Putting It All Together Table 1 shows that trailing 12-month profit growth of 17% and debt growth of 6.5% led to gross corporate leverage of 6.95, which translates to a fair value default rate of 3.6%. Table 1 also shows where the fair value default rate will head during the next 12 months based on different scenarios for profit and debt growth. Table 1Default Rate Scenarios For example, if profits grow by 5% and debt growth is between 0% and 8%, then the fair value default rate will be between 3.5% and 4.1% one year from now. This seems like a reasonable scenario based on our macro forecast. A scenario that would result in a default rate that is much higher than the current Moody’s baseline forecast of 1.7%. And One More Thing Though they are not included in our model, job cut announcements are a fairly reliable coincident indicator of corporate defaults. Recently, job cut announcements have clearly bottomed even as the default rate has continued to fall (Chart 8). This is a clear warning sign that the default rate might head higher in the coming months. Chart 8Warning Sign From Job Cuts Bottom Line: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. It increasingly looks like the second half of 2019 will be more challenging for corporate credit. Are Investors Adequately Compensated For Default Risk? Forecasting the default rate is important, but it is only one side of the coin when it comes to corporate bond investing. The other relevant question is whether current spreads offer adequate compensation for expected defaults. At present, the average option-adjusted spread (OAS) on the Bloomberg Barclays High-Yield index is 388 bps. If we assume that defaults occur in line with the Moody’s baseline forecast during the next 12 months, then we would expect default losses of approximately 90 bps (assuming a 49% recovery rate).2 That translates to an excess junk spread of 298 bps, well above the historical average realized excess spread of 250 bps. In other words, investors should expect better than average excess junk returns if the Moody’s baseline default rate forecast turns out to be correct. However, our analysis suggests that the default will be significantly higher during the next 12 months. If we assume a 3.5% default rate, more in line with our macro forecast, and a slightly lower recovery rate of 45%, then the excess spread available in the high-yield index falls to 198 bps. This number is still positive, so unless there is significant spread widening investors should still earn a positive excess return versus Treasuries, but it is considerably below average historical levels. Another factor to consider is the historical correlation between junk spreads and the Moody’s baseline default rate forecast. We find that the average high-yield OAS has the strongest positive correlation with the 9-month forward Moody’s baseline default rate expectation (Chart 9). In other words, if our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. Chart 9Default Rate Revisions Will Lead To Wider Spreads Bottom Line: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy While this report has focused on detecting early warning signs of default risk, that is not the only thing that matters for corporate spreads. We continue to believe that spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth.3 The purpose of this report is to stress that our current overweight stance on corporate bonds is unlikely to last through to the end of the year. First, if spreads tighten during the next few months leading to an easing in overall financial conditions, then the Fed will probably turn more hawkish in the second half of 2019 and monetary policy will shift from being a tailwind for corporate credit to a headwind. This shift could occur at around the same time that corporate defaults start to exceed current expectations. As a matter of strategy, we have published spread targets for each corporate credit tier based on average spread levels seen during similar stages of past economic cycles (Charts 10A & 10B).4 We will be quick to move off our overweight stance once these spread targets are achieved. Note that Aaa spreads are already below target. We recommend that investors avoid Aaa-rated corporate bonds. Chart 10AInvestment Grade Spread Targets Chart 10BHigh-Yield Spread Targets While the current environment remains positive, it increasingly looks like the second half of 2019 will be more challenging for corporate credit. Stay tuned. Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further details on the amount of labor market slack in the economy please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 We forecast the recovery rate based on its inverse historical relationship with the default rate. A higher default rate implies a lower recovery rate, and vice-versa. 3 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 For more details on our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com

Overweight Last summer we took refiners down to a below benchmark allocation as all of the good news was perfectly reflected in soaring relative share prices (top panel), at a time when cracks were forming. Today, refiners paint a near exact opposite picture compared with last July. Relative share prices are no longer rising by 50%/annum. Instead, momentum has collapsed and is now contracting (middle panel). Accordingly, we were compelled to book gains of 21% yesterday and boost exposure all the way to overweight. Sell-side analyst exuberance has turned into outright pessimism: refiners’ profits are expected to trail the broad market in the coming year. By comparison, last summer they were penciled in to beat the market by 30 percentage points (bottom panel). Refiners’ riches move in tandem with crack spreads. When refining margins widen, profits excel and vice versa. Now that refining margins are in a slingshot recovery, refining ills will turn into fortunes (bottom panel). Bottom Line: Yesterday we lifted the S&P oil & gas refining & marketing index to overweight all the way from a below benchmark allocation, crystalizing 21% in relative profits since last summer’s inception. Please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR – PSX, MPC, VLO, HFC.  

Highlights Portfolio Strategy As growth becomes scarce, investors flock to sectors that are slated to outgrow the broad market and shy away from the ones that are forecast to trail the SPX’s growth rate. This week we rank sectors and subsectors by EPS growth in our universe of coverage, and identify sweet and trouble spots. Fired up crack spreads, firming refining industry operating metrics, reaccelerating exports along with washed out technicals and compelling valuations, all signal that the time is ripe to buy into refining weakness. The cable industry’s demand headwinds are reflected in depressed relative valuations at a time when industry pricing power is trying to stage a comeback and a drifting lower greenback may also provide positive profit offsets. Stick with a benchmark allocation. Recent Changes Boost the S&P Oil & Gas Refining & Marketing index to overweight all the way from underweight today, locking in relative profits of 21%. Table 1 Feature Equities broke out last week and surpassed the upper band of their recent trading range, despite economic data releases that continued to surprise to the downside. Two weeks ago, we cautioned investors not to put cash to work as a tactical indigestion period loomed, with the SPX facing stiff resistance near the 2,800 level. In addition, we posited that most of the good news related to the U.S./China trade spat front was reflected in the S&P 500’s V-shaped recovery (top panel, Chart 1). In relative terms, the bottom panel of Chart 1 confirms that the easy money has already been made on the assumption of a positive resolution to the U.S./China trade dispute. Chart 1Trade Deal Priced In Going forward, the earnings juggernaut will have to remain in place in order for stocks to vault to fresh all-time highs, likely in the back half of the year. The Trump administration’s massive fiscal stimulus artificially fueled profit growth last year both by lowering the corporate tax rate and by encouraging overseas cash repatriation. The latter boosted share buybacks to an all-time record. Despite 24% EPS growth and $1tn in equity retirement, the SPX ended 2018 6% lower. Why? It became clear that EPS growth was headed lower. In order to gauge trend EPS growth we opt to use EBITDA, a cash flow proxy measure that strips out the direct impact of last year’s fiscal easing. Chart 2 clearly shows that trend growth took a step down following the positive base effects of the GFC-induced collapse and averaged close to 5%/annum from 2012 to 2014. Subsequently, the late-2015/early-2016 manufacturing recession sunk EBITDA into contraction, but the euphoria surrounding the newly elected President pushed trend EBITDA growth to near 10%/annum for two full years in 2017 and 2018. Chart 2Return To 5% Growth? Since the late-2018 peak, 12-month forward EBITDA growth continues to drift lower and is now hovering just shy of 3%. Our sense is that 5% organic profit growth is consistent with nominal GDP printing 4%-4.5% at this stage of the business cycle, signaling that a return to the 2012-2014 growth backdrop is likely later in the year. As a reminder, positive profit growth in calendar 2019 remains one of the three pillars underpinning stocks that we have highlighted since the beginning of this year. Stocks have come full circle recovering all of last December’s losses, but in order to make fresh all-time highs, profits will have to deliver. We deem that an earnings validation phase is transpiring and there are early signs that profit growth will trough sometime in the first half of the year. Not only has EBITDA breadth put in a bottom (Chart 2), but also economically hypersensitive indicators suggest that forward EBITDA growth will soon tick higher. Namely, the ISM manufacturing new orders component has perked up on a year-over-year basis. The trough in lumber futures momentum corroborates this message, as does the tick higher in the U.S. boom/bust indicator (Chart 3). Chart 3Growth Green-shoots Given the current macro backdrop and awaiting the profit validation, when growth becomes scarce investors flock to sectors that are outgrowing the broad market and shy away from ones that trail the SPX’s growth rate. Typically, in recessionary times that would equate to investors bidding up defensive sectors that command stable cash flow businesses and avoiding highly cyclical industries. But, BCA does not expect a recession in the coming year. Thus, in order to identify high growth sectors that should outperform during the current soft patch and growth laggards that should underperform, we compiled a table with the GICS1 sectors and all the subsectors we cover. First, we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 2). We aim to reproduce this table once a quarter. Table 2Identifying S&P 500 Sector EPS Growth Leaders And Laggards The third columns in Table 2 show the sector growth rate relative to the SPX. The final columns in Table 2 highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Industrials and financials (we are overweight both) are leading the pack outpacing the broad market by 410bps and 350bps, respectively, and enjoy a rising profit trend. On the flip side, energy (overweight) and real estate (underweight) trail the broad market by 490bps and 1480bps, respectively, and showcase a deteriorating EPS trend. With regard to energy, we first identified that analysts are really punishing this sector in the January 22 Weekly Report and the sector’s 2019 EPS contribution was and remains negative.1 Our overweight call will be offside if oil prices suffer a new setback, but our Commodity & Energy strategy service remains bullish on oil, implying relative EPS outperformance in 2019. Year-to-date, energy has bested the SPX by 170bps. This week, we make an energy sector subsurface tweak, and also update a communication services subgroup. Light My Fire Last summer we took refiners down to a below benchmark allocation as all of the good news was perfectly reflected in soaring relative share prices (top panel, Chart 4), at a time when cracks were forming. Now we are compelled to book gains of 21% and boost exposure all the way to overweight. Chart 4Crack Spreads Are On Fire Today, refiners paint a near exact opposite picture compared with last July. Relative share prices are no longer rising by 50%/annum. Instead, momentum has collapsed and is now contracting (middle panel, Chart 4). Sell-side analyst exuberance has turned into outright pessimism: refiners’ profits are expected to trail the broad market in the coming year. By comparison, last summer they were penciled in to beat the market by 30 percentage points (bottom panel, Chart 4). Granted M&A activity had also added fuel to the fire, but now all the hot air has come out of the refining industry, and then some. Refiners’ riches move in tandem with crack spreads. When refining margins widen, profits excel and vice versa. Now that refining margins are in a slingshot recovery, refining ills will turn into fortunes (bottom panel, Chart 4). Importantly, wide Brent-WTI spreads underpin crack spreads. Moreover, the crude oil versus refined product inventory backdrop currently reinforces a widening in refining margins. In absolute terms, gasoline stockpiles are being worked off (gasoline inventories shown inverted, bottom panel, Chart 5) and grinding higher demand for refined petroleum products (top panel, Chart 5) will further tighten the industry’s inventory outlook. Chart 5Healthy Supply/Demand Backdrop One way domestic refiners are taking advantage of the still wide Brent-WTI differential is via the export markets. Net refined products exports are running at over 3mn barrels/day (bottom panel, Chart 6), and the softening greenback since November will further boost profits with a slight lag as U.S. refining exports will grab an even larger slice of the global pie (U.S. dollar shown inverted and advanced, middle panel, Chart 6). Chart 6U.S. Dollar Softness Is A Boon To Refining Profits On the valuation front, both the relative forward P/E and P/S have undershot their respective historical means and EPS breadth is as bad as it gets, offering investors an excellent entry point in the pure-play oil & gas refining industry (Chart 7). Chart 7Extreme Analyst Pessimism Reigns In sum, fired up crack spreads, firming refining industry operating metrics, reaccelerating exports along with washed out technicals and compelling valuations, all signal that the time is ripe to buy into refining weakness. Bottom Line: Lift the S&P oil & gas refining & marketing index to overweight all the way from a below benchmark allocation, crystalizing 21% in relative profits since last summer’s inception. The ticker symbols for the stocks in this index are: BLBG: S5OILR – PSX, MPC, VLO, HFC. Cable’s Down But Not Out Cable & satellite stocks had been in an uninterrupted run from the depths of the Great Recession until the peak in relative share prices in August 2017. Since then, cord cutting news and the proliferation of on demand streaming services have wreaked havoc on the industry and cable stocks have trailed the market by over 33% from peak to the most recent trough (top panel, Chart 8). Chart 8Cable Signals Are… This deteriorating demand backdrop more than offset the industry’s reaction function, which has been intra and inter-industry M&A. Now that the M&A dust has settled, what is next in store for the industry? We reckon that leading profit indicators are a mixed bag and we continue to recommend a benchmark allocation in this niche communications services subgroup. The top panel of Chart 8 shows that relative outlays on cable are on a slippery slope, and will continue to weigh heavily on relative share prices for the coming quarters. Nevertheless, the ISM services survey ticked higher recently and is on the cusp of making fresh recovery highs, unlike its sibling the ISM manufacturing survey. This is encouraging news for cable executives and suggests that demand for cable services may not be as moribund as the PCE release is projecting (second panel, Chart 9). Chart 9..A Mixed… While the cable demand backdrop is unclear, industry pricing power has managed to exit deflation. Cable selling prices have been positive for the better part of the past decade, but starting in late-2017 they collapsed by roughly 600bps relative to overall inflation. True, this deflationary impulse dented profit margins, but currently the industry’s selling prices – and to a much lesser extent profit margins – are in a V-shaped recovery mostly courtesy of base effects (middle & bottom panels, Chart 8). Absent a sustained hook up in cable demand, selling price inflation will prove fleeting and the recent margin expansion phase will also lose steam. Meanwhile, cable stocks and the U.S. dollar enjoy a positive correlation as most of the constituents’ earnings are derived domestically (Chart 10). The recent U.S. dollar softness will, at the margin, weigh on relative profits and thus relative share prices, especially if the Fed stays pat and refrains from raising rates for the rest of the year as the bond market currently expects. Chart 10…Bag Finally, earnings breadth continues to fall, but relative valuations are still well below the historical mean (third & bottom panels, Chart 9). Netting it all out, cable’s demand headwinds are well reflected in depressed relative valuations at a time when industry pricing power is trying to stage a comeback and a drifting lower greenback may both provide positive profit offsets. Bottom Line: Remain on the sidelines in the S&P cable & satellite index. The ticker symbols for the stocks in this index are: BLBG: S5CBST – CMCSA, CHTR, DISH.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights We are asked nearly everywhere we go about the Fed’s independence, … : The Fed’s independence is an especially popular topic overseas, and it typically takes some persuasion to bring clients around to our view that it’s not at risk. … and Jay Powell shed some light on how the Fed intends to protect it: Since Bernanke, the Fed has fought back against criticism by attempting to open a window on its operations, and showing how they benefit all Americans. Powell’s Stanford speech and 60 Minutes appearance continued the transparency and charm offensive. The housing debate remains unresolved, but year-to-date activity has supported our sanguine outlook: Demand came back smartly following the decline in mortgage rates, and there is still no sign of overheating or oversupply on the horizon. Coincident indicators have a place, too: We do not include the three-month moving average of the unemployment rate in our recession indicator because it’s only a coincident indicator, but it does help to validate the leading indicators we follow. Feature BCA was established on our founder’s insight that tracking money flows through the banking system informs the future direction of the economy and financial markets. Monetary policy is of the utmost importance to BCA as a firm, and the fed funds rate cycle is a pillar of our U.S. Investment Strategy asset-allocation framework. That said, spending time parsing Fed speeches can be unavailing and tedious. Although we continually monitor comments from the Fed governors and regional bank presidents, we don’t often write about them. Since last summer, when the President first began expressing his displeasure with the Fed 140 characters at a time, we have been inundated with questions about the Fed’s independence, especially from overseas clients. We have noted repeatedly that conflicts between the White House and the Fed are nothing new. They are largely inevitable, and highlight the importance of insulating central banks from political pressure. A recent television interview and speech by Fed Chair Powell illustrated how the Fed hopes to safeguard its independence. The speech also sketched out some of the arguments supporting a potential re-interpretation of the Fed’s price stability mandate. If the Fed really were to pursue some sort of price-level targeting, the implications could be profound. TRIGGER ALERT: The following sections may promote cardiac distress among Austrian School devotees and other hard-money types. An Open, Friendly Fed Fed Chair Jerome Powell sat for an extended interview with venerable U.S. television news magazine 60 Minutes, broadcast in prime time Sunday March 10th. His comments carried no new information for Fed watchers, but appearances on 60 Minutes are not intended for Fed watchers, any more than Janet Yellen’s stop to watch community college students welding on her first official trip as Chair was. Powell appeared briefly alongside Yellen and Ben Bernanke in the 60 Minutes segment, and his appearance followed his predecessors’ public-relations game plan closely: defend the Fed’s independence, and explain the Fed’s role in managing the economy, so as to dispel some of the mystery about its mission and modus operandi. It was Bernanke who first sat for 60 Minutes, in 2009 and 2010, attempting to broadcast the Fed’s aims to the general public. Yellen extended the public outreach, as we noted in these pages five years ago, following her debut appearance:1 Not only did she make her first major outside appearance at a community development conference, she placed the plight of three locals grappling with unemployment and/or underemployment at the center of her remarks. She dined at a community-college training restaurant on the night before the speech, and went to another community college after delivering it, where she visited a shop floor and watched students weld. One could easily have mistaken her for a candidate for public office, given the photo ops and her dogged efforts to drive home the message that the labor market heads the Fed’s list of concerns. A New Take On Price Stability Powell’s 60 Minutes interviewer occasionally went out of his way to express skepticism about the Fed and its pre-crisis performance. A voiceover pointed to Powell’s academic record and Wall Street experience as signs of privilege, rather than evidence of aptitude or acumen. As Powell noted in a speech at Stanford University two days before the 60 Minutes interview aired, the current climate is one of “intense scrutiny and declining trust in public institutions” globally. Outwardly welcoming the scrutiny, and seeking to shore up the public’s trust, the Fed plans to hold a series of town-hall-style “Fed Listens” events around the country. The post-crisis Fed has tried to protect its independence by becoming more transparent. The Fed’s listening tour will be a part of its year-long review of monetary policy strategy, tools and communication practices, but we were most interested in Powell’s comments on strategy as it relates to the Fed’s price-stability mandate. Concerned that the secular decline in rates will regularly make the zero lower bound a binding policy constraint, the Fed is exploring the potential for some sort of price-level-targeting strategy. As a part of its review, it is asking, “Can the Federal Reserve best meet its statutory objectives with its existing monetary policy strategy, or should it consider strategies that aim to reverse past misses of the inflation objective?” When targeting the inflation rate, the Fed hasn’t much sweated inflation undershoots. Price-level targeting would represent a significant change from managing to the 2% annual inflation target on a non-cumulative basis. As shown in Chart 1, the Fed has executed its price-stability mandate by aiming for 2% annual inflation, as measured by the headline PCE price index. In theory, each year-over-year change is an independent event, considered without regard to prior overshoots or undershoots. The post-crisis shortfalls have no explicit bearing on the price-stability goal going forward, though perhaps they have made the Fed a little more inclined to wait until it sees the whites of inflation’s eyes before it removes accommodation in earnest. Chart 1Traditional Policy Has Been Directed At Keeping Prices From Rising Too Fast ... A price-level-targeting framework, on the other hand, would take its cues directly from past overshoots and undershoots. Whereas the Fed simply aimed at 2% every year in the old regime, under price-level targeting, it would be attempting to stay in continual contact with the 2% trend-growth line in Chart 2. Had price-level targeting been in place since the crisis began, the cumulative misses from 2008 on would eventually have to be made up. If the price-level target were to be reached by the end of this year, 2019 inflation would have to be 8.1%; by the end of next year, annualized inflation would have to be 5%; in five years, 3.2%; and in ten years, 2.6% (Table 1). Chart 2... Price-Level Targeting Seeks To Ensure They've Risen Enough Table 1Price-Level Targeting Higher inflation rates would presumably push Treasury bond volatility higher (Chart 3, top panel), along with the term premium (Chart 3, bottom panel). The increased uncertainty inherent in hitting a moving target would also help stoke interest-rate volatility, which would ripple out into the rest of financial markets. The Fed wouldn’t deliberately pursue a policy that stokes volatility unless it delivers other significant benefits. By boosting inflation expectations, price-level targeting could help stave off a deflationary mindset like the one that has crippled Japan since the bursting of its bubble three decades ago. More immediately, it could help combat the secular stagnation effects Larry Summers has been warning about for the last several years by making it easier for the Fed to reduce real rates. Chart 3Lower Inflation Has Helped Tamp Down Treasury Volatility And The Term Premium There is no sign that a change in the Fed’s monetary policy strategy, as it relates to price stability, is coming. The Fed performs a great deal of research and develops hypothetical game plans for a wide range of hypothetical economic outcomes. Discussions about price-level targeting are only conceptual for now, and the Fed will not necessarily adopt it. If price-level targeting were to become mainstream policy, it might better equip central banks with a tool for counteracting disinflationary impulses and could turn out to be marginally equity-friendly and bond-unfriendly. If it were to shift to a price-level-targeting framework, the Fed would be equally concerned about undershoots and overshoots. Housing Update We were unperturbed by the softness in the U.S. housing market when we published our housing Special Reports late last year. Three months into 2019, the data have supported our view, and we remain confident that the housing market does not represent the leading edge of an imminent downturn. We expect price-level targeting would increase financial-market volatility, at least when it’s first implemented. We highlighted in those Special Reports2 that the share of residential investment as a percentage of GDP has been steadily decreasing over the past 70 years, and is down to just 3% today. Although housing remains an important component of the U.S. economy and large fluctuations in the space will surely impact other segments of the economy, it is unlikely to exert a powerful drag. Home values also comprise a sizable portion of households’ net worth, and a decline in house prices will affect consumption patterns, but investors probably exaggerate the impacts. Housing now accounts for less than 15% of household equity – well below its 1980s and 2006 peaks – whereas pension entitlements and direct and indirect equity holdings account for 25% each. The rate at which mortgage rates change can exert a powerful impact on home sales and residential construction activity. 2018’s soft housing data was likely the byproduct of the yearlong rise in mortgage rates. Home sales and construction tend to decline in the six-month period after mortgage rates rise (Chart 4). Although higher mortgage rates took a toll on housing affordability last year, it remained at comfortable levels relative to history, and has already regained a good bit of ground now that the 30-year mortgage rate has declined by half a percentage point since its November peak. Mortgage applications have duly picked up since the end of last year. Chart 4Mortgage Rates Hurt Housing Last Year, But Are Poised To Help It This Year Most importantly for the overall economy, there is no evidence of construction excess. In contrast to the decade preceding the crisis, there is still plenty of room for new supply as housing starts still lag the pace of new household formations. New-home inventories have increased, but only back to their pre-housing boom range, and they amount to no more than a fraction of existing-home inventories, which are bumping around 30-year lows (Chart 5). The aggregate supply of homes for sale is not at all a matter for concern. Chart 5Housing Inventory Levels Are Low Bottom Line: The outlook for the housing market has improved since the end of the year. Homes remain affordable relative to history, and the aggregate inventory of homes for sale is the lowest it’s been since the mid-‘90s. The housing market still looks okay to us. Unemployment Is A Coincident Indicator We received a question from a client following last week’s review of our bond-upgrade and equity-downgrade checklists. Why do we include the three-month moving average of the unemployment rate in the equity checklist, but not our recession indicator? The simple answer is that the recession indicator is meant to be forward-looking.3 The unemployment measure has a sterling track record of coinciding with recessions, but it does not lead them (Chart 6). Chart 6A Coincident Indicator The three components of our recession indicator – an inverted yield curve, year-over-year contraction in the Leading Economic Indicator (LEI), and an above-equilibrium fed funds rate – have all consistently preceded recessions (Table 2). When combined into a single indicator, they’ve done so an average of just over six months before the onset of recessions, in line with the S&P 500’s average peak. The unemployment rate has been a coincident indicator, sending its signal an average of just under a month after recessions begin (Table 3). Table 2Lead Times For Indicator Components And Bear Markets Table 3Unemployment And Postwar Recessions The unemployment rate’s three-month moving average has a perfect record of coinciding with recessions, but indicators have to lead to be included in our recession alarm system. Tacking on an extra month to account for the lag in the data release, the unemployment rate alerts an investor to a recession two months after it’s begun. That’s too late to help sidestep the brunt of the S&P 500’s bear-market declines, so we leave it out of our recession indicator. Unemployment’s recession signal is nonetheless a good bit more timely than the NBER’s official recession declaration, which has come an average of eight months after the start of the last five recessions. The three-month moving average of the unemployment rate provides reliable confirmation that recessions have begun, and that has earned it a place in our equity checklist. Doug Peta, CFA   Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Footnotes 1      Please see the April 7, 2014 U.S. Investment Strategy Weekly Report, “Fed To America: We Care.” Available at usis.bcaresearch.com. 2      Please see the November 19, 2018 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar.” Available at usis.bcaresearch.com. 3      Please see the August 13, 2018 U.S. Investment Strategy Special Report, “How Much Longer Can the Bull Market Last?” Available at usis.bcaresearch.com.

Highlights Global equities will remain rangebound for the next month or so, but should move decisively higher as economic green shoots emerge in the spring. A revival in global growth will cause the recent rally in the U.S. dollar to stall out and reverse direction, setting the stage for a period of dollar weakness that could last until the second half of next year. Rising inflation will force the Fed to turn considerably more hawkish in late-2020 or early-2021. This will cause the dollar to surge once more. The combination of a stronger dollar and higher interest rates will trigger a recession in the U.S. in 2021, which will spread to the rest of the world. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year. Feature Stocks Temporarily Stuck In The Choppy Trading Range We argued at the end of February that global equities and other risk assets would likely enter a choppy trading range in March as investors nervously awaited the economic data to improve.1 Recent market action has been consistent with this thesis, with the MSCI All-Country World Index falling nearly 3% at the start of the month, only to recoup its losses over the past few days. We expect stocks to remain in a holding pattern over the coming weeks, as investors look for more evidence that global growth is bottoming out. The U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 1). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. This makes the U.S. a low-beta play on global growth (Chart 2). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 1The Dollar Is A Countercyclical Currency Chart 2The U.S. Is A Low-Beta Play On Global Growth Given the dollar’s countercyclical nature, it is not surprising that the slowdown in global growth over the past 12 months has given the greenback a lift. The broad trade-weighted dollar has strengthened by almost 8% since February 2018, putting it near the top of its post 2015-range (Chart 3). Chart 3The Dollar Has Gotten A Lift From Global Growth Disappointments Stocks Will Rally And The Dollar Will Weaken Starting In The Spring We expect the U.S. dollar to strengthen over the coming weeks as global economic data continues to underwhelm. However, an improvement in leading economic indicators in the spring will set the stage for a reacceleration in global growth and a decline in the dollar in the second half of this year. The combination of stronger growth and a weaker dollar later this year should be highly supportive of global equities. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks. We do not have a strong view on U.S. versus international equities at the moment, but expect to upgrade the latter once we see more confirmatory evidence that global growth is bottoming out. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks.   A Stronger China Will Lead To A Weaker Dollar Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. The deceleration in global growth in 2018 was largely the consequence of China’s deleveraging campaign. China’s slowdown led to a falloff in capital spending throughout the world. Weaker Chinese growth also put downward pressure on the yuan, pulling other EM currencies lower with it (Chart 4). All this occurred alongside an escalation in trade tensions, further dampening business sentiment. Chart 4EM Currencies Are Off Their Early 2018 Highs While it is too early to signal the all-clear on the trade front, the news of late has been encouraging. A recent Bloomberg story described how Trump watched approvingly as Asian stocks rose and U.S. futures rallied following his decision to delay the scheduled increase in tariffs on Chinese goods.2 As a self-professed master negotiator, Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the deal was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky if the agreement had failed to bring down the bilateral trade deficit — an entirely likely outcome given how pro-cyclical U.S. fiscal policy currently is.  At this point, however, Trump can crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized after he has been re-elected. This means that we are entering a window over the next 12 months where Trump will want to strike a deal. For their part, the Chinese want as much negotiating leverage with the Trump administration as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Admittedly, credit growth surprised on the downside in February. However, this followed January’s strong showing. Averaging out the two months, credit growth appears to be stabilizing on a year-over-year basis. Conceptually, it is the change in credit growth that correlates with GDP growth.3 Thus, merely going from last year’s pattern of falling credit growth to stable credit growth would still imply a positive credit impulse and hence, an uptick in GDP growth. In practice, we suspect that the Chinese authorities will prefer that credit growth not only stabilize but increase modestly. In the past, this outcome has transpired whenever credit growth has fallen towards nominal GDP growth (Chart 5). The prospect of a rebound in credit growth in March was hinted at by the PBOC, which spun the weak February data as being caused by “seasonal factors.” Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Europe: Down But Not Out Stronger growth in China will help European exporters. Euro area domestic demand will also benefit from a rebound in German automobile production, the winding down of the “yellow vest” protests in France, and incrementally easier fiscal policy. In addition, the ECB’s new TLTRO facility should support credit formation, particularly in Italy where the banks remain heavily reliant on ECB funding. Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. Euro area financial conditions have eased significantly over the past three months, which bodes well for growth in the remainder of the year. It is encouraging that the composite euro area PMI has rebounded to a three-month high. The expectations component of the euro area confidence index has also moved up relative to the current situation component, which suggests further upside for the PMI in the coming months (Chart 6). Chart 6Easing Financial Conditions Bode Well For Euro Area Growth The selloff in EUR/USD since last March has been largely driven by a decline in euro area interest rate expectations (Chart 7). If euro area growth accelerates in the back half of the year, the market will probably price back in a few rate hikes in 2020 and beyond. Chart 7EUR/USD Sell-Off Has Been Driven By Falling European Rate Expectations What Will The Fed Do? Of course, the degree to which a steeper Eonia curve benefits EUR/USD will depend on what the Fed does. The 24-month discounter has fallen from over +100 bps in March 2018 to -25 bps today, implying that investors now believe that U.S. short rates will fall over the next two years (Chart 8). Chart 8The Fed's Dovish Messaging Has Worked... Almost Too Well We expect the Fed to raise rates more than what is currently priced into the curve, thus justifying a short duration position in fixed-income portfolios. However, the Fed’s newfound “baby step” philosophy will probably translate into only two hikes over the next 12 months. Such a gradual pace of Fed rate hikes is unlikely to prevent the euro from appreciating against the dollar starting in the middle of this year, especially in the context of a resurgent global economy. We do not expect any major inflationary pressures to emerge in the near term. In contrast to the euro, the yen should depreciate against the dollar in the back half of this year. The yen is a “risk-off” currency and thus tends to weaken whenever global risk assets rally (Chart 9). The government is also about to raise the sales tax again in October, a completely unnecessary step that will only hurt domestic demand and force the Bank of Japan to prolong its yield curve control regime. We would go long EUR/JPY on any break below 123. Chart 9The Yen Is A Risk-Off Currency A Blow-Off Rally In The Dollar Starting In Late-2020 What could really light a fire under the dollar is if the Fed began raising rates aggressively while the global economy was slowing down. In what twisted parallel universe could that happen? The answer is this one, provided that inflation rose to a level that evoked panic at the Fed. We do not expect any major inflationary pressures to emerge in the near term. The growth in unit labor costs leads core inflation by about 12 months (Chart 10). Thanks to a cyclical pickup in productivity growth, unit labor cost inflation has been trending lower since mid-2018. However, as we enter late-2020, if the labor market has tightened further by then, wage growth will likely pull well ahead of productivity growth, causing inflation to accelerate. Chart 10Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being All things equal, higher inflation is bearish for a currency because it implies a loss in purchasing power relative to other monies. However, if higher inflation spurs a central bank to hike policy rates by more than inflation has risen – thus implying an increase in real rates – the currency will tend to strengthen. Chart 11 shows the “rational expectations” response of a currency to a scenario where inflation suddenly and unexpectedly rises by one percent relative to partner countries and stays at this higher level for five years while nominal rates rise by two percent. The currency initially appreciates by 5%, but then falls by 2% every year, eventually finishing down 5% from where it started.4 The yen should depreciate against the dollar in the back half of this year. The real world is much messier of course, but we suspect that the dollar will stage a final blow-off rally late next year or in early-2021 (Chart 12). Since the Fed will be hiking rates in a stagflationary environment at that time, global growth will weaken, further boosting the dollar. The resulting tightening in both U.S. and global financial conditions will likely trigger a global recession and a bear market in stocks. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Jennifer Jacobs and Saleha Mohsin, “Trump Pushes China Trade Deal to Boost Markets as 2020 Heats Up,” Bloomberg, March 6, 2019. 3      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 4      The 2% annual decline in the currency is necessary for the real interest parity condition to be satisfied. 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