Developed Countries
Highlights The chaotic conclusion to last weekend's G7 summit in Charlevoix is a reminder that the specter of trade wars will not fade quietly into the night. A trade war would hurt the U.S., but would punish the rest of the world even more. The U.S. dollar typically strengthens when global trade slows. Despite President Trump's antics, the dollar is at little risk of losing its status as the world's premier reserve currency. Fiscal stimulus should keep U.S. growth above trend well into next year, allowing the Fed to maintain its once-per-quarter pace of rate hikes. We are currently overweight global equities, but we expect to shift to neutral before the end of the year. Feature Hit First, Ask Questions Later Donald's Trump's negotiating style - hit as hard as you can and then compromise - has worked well in dealing with tin-pot dictators, at least judging by the apparent outcome of this week's Singapore summit with Kim Jong-Un. It has also worked well throughout Trump's career as a real estate developer. However, as the breakdown of last weekend's G7 summit demonstrates, it is not clear if it is a winning strategy in the realm of international trade. Down-on-their-luck creditors may be willing to settle for twenty cents on the dollar when they had been promised one hundred, but governments have their citizens to answer to, and national pride often trumps (ahem) narrow financial interests in such matters. How Not To Fight A Trade War The U.S. is a fairly closed economy and hence a trade war probably would not have severe effects on growth. However, the way Trump is waging his war ensures that whatever impact it has on the domestic economy will be negative. This is not only because Trump's tariffs are certain to invite retaliation; it is also because Trump is targeting intermediate goods - goods that are used as inputs into production of final goods - for tariffs. Chart 1Rising Productivity In The Steel Sector ##br##Caused Employment To Decline Consider the case of steel. Today, the U.S. steel industry employs just 145,000 workers, down from 203,000 workers in 2000. In contrast, there are about two million workers employed in steel-consuming sectors of the economy.1 A reasonable rule-of-thumb from the international trade literature is that a one-percent increase in foreign prices causes domestic prices to rise by about half a percent. This is mainly because domestic producers end up capturing some of the gains from tariffs through higher profit margins. A 25% increase in steel tariffs would thus raise steel prices by around 12.5%. Higher steel prices will lead to higher prices for many American goods such as automobiles, some of which are exported abroad. It is actually quite conceivable that steel tariffs would reduce exports more than they would depress imports, leading to a wider trade deficit. Ironically, foreign competition probably explains only a small fraction of the decline in U.S. steel employment. The U.S. produces roughly as much steel now as it did in 2000 (Chart 1). What has changed is that output-per-worker in the steel industry has increased by a total of 43% since then. Blame technological progress, not trade. Trade Wars, The Fed, And The Dollar Chart 2The Dollar Tends To Strengthen ##br##When Global Trade Deteriorates Even if higher tariffs did produce a one-off increase in consumer and producer prices, slower GDP growth would likely prompt the Fed to moderate the pace of rate hikes. If the stock market declined in sympathy with slower growth and rising protectionist sentiment, the resulting tightening in financial conditions would further justify a go-slow approach to monetary normalization. All things equal, a more dovish-than-expected Fed would likely translate into a weaker dollar. All things are not equal, however. A trade war would probably hurt the rest of the world more than the U.S. This is partly because the rest of the world is more open to trade, but it is also because the rest of the world runs a trade surplus with the U.S., which makes it more vulnerable to a broad-based decline in trade volumes. Chart 2 shows that the dollar tends to strengthen when global trade is weakening. Reserve Currency Status In Jeopardy? An often-heard counterargument to the "protectionism is good for the dollar" view is that at some point, rising trade tensions could undermine the dollar's standing as the world's premier reserve currency. The U.S. has run a trade deficit almost continuously for 40 years, accumulating 40% of GDP in net liabilities to the rest of the world in the process (Chart 3). If foreign buyers decide to scale back their purchases of U.S. assets, the dollar could swoon. Chart 3U.S. External Deficit: 40 Years And Counting Trump's statement at the conclusion of the G7 summit that "We're like a piggy bank that everybody's robbing" seems to imply that he thinks that foreigners are living beyond their means by draining the U.S. of its wealth. The opposite is actually the case: The U.S. has been able to spend more than it earns for decades precisely because foreigners have been willing to deposit ever more money into the U.S. piggy bank. Fortunately for the greenback, America's status as the world's piggy bank of choice is unlikely to change any time soon. The euro area remains hopelessly divided. The Italian bond market - the biggest in Europe - has once again become the object of investor angst. Japan is drowning in a sea of government debt, with debt monetization probably the only viable solution. China would like to transform the renminbi into a global reserve currency, but opacity in government decision-making, and a still largely closed capital account, will limit any progress towards that goal for some time to come. China and other countries could try to "punish" the U.S. government by buying fewer Treasury bonds, but where would that get them? The average maturity of U.S. government debt is less than six years. The Fed, not China, largely sets rates at that portion of the yield curve. Granted, a decline in Treasury purchases would reduce the demand for dollars. However, that would just put upward pressure on the value of the renminbi. China does not want a stronger currency. For all the talk about how America's rivals are keen to reduce their dollar holdings, their share of global central bank reserves has actually climbed over the past two decades, largely because they have been gobbling up dollars to keep their own currencies from appreciating (Chart 4). Today, nearly two-thirds of global currency reserves are denominated in dollars, a higher proportion than when the Berlin Wall fell in 1989 (Chart 5). Chart 4Geopolitics Is Not Driving Demand For Treasurys Chart 5The Dollar Remains The Preferred Reserve Currency A Not So Exorbitant Privilege Chart 6The U.S. Term Premium Is ##br##Higher Than Elsewhere In any case, it's not clear how much the U.S. benefits from having a reserve currency. There is little evidence that U.S. long-term bond yields are lower than they would otherwise be because of foreign reserve accumulation. Chart 6 shows that the term premium - the difference between the yield on a long-term bond and the market's expectation of the average level of short-term rates over the life of the bond - is higher in the U.S. than in the rest of the world. If foreign central bank purchases were pushing down U.S. bond yields, one would expect to see the reverse pattern. The only tangible benefit the United States gets from having a reserve currency is that the U.S. Treasury can issue currency to foreigners who hold it as a store of value rather than spending it. This amounts to an interest-free loan to the U.S. government. This so-called "seigniorage revenue" is not trivial: Last year, foreigners increased their holdings of U.S. currency by $60 billion.2 However, this is still less than one-third of one percent of U.S. GDP. What Really Explains Why The U.S. Has A Current Account Deficit? It is often argued that the dollar's reserve currency status has allowed the U.S. to run large current account deficits. However, Australia has run even bigger current account deficits than the U.S., and it does not have a reserve currency. What matters in the end is whether people trust you to pay back your debts, not whether you have a reserve currency. The rate of return that a country offers investors is also important. As we explained in our weekly report on April 6th, an often-overlooked reason for why the U.S. and Australia run current account deficits is that both countries enjoy faster trend growth than most of their peers.3 Faster growth tends to push up the neutral real rate of interest, otherwise known as r-star. A country with a relatively low neutral rate needs to have an "undervalued" currency that is expected to appreciate over time in order to compensate investors for the subpar yield that its bonds provide. As sketched out in Chart 7, this results in current account surpluses for countries with low neutral rates, and current account deficits for countries with high neutral rates. Chart 7Interest Rates And Current Account Balances Commentators who claim that the euro is cheap are barking up the wrong tree. The euro needs to be cheap to entice investors into holding low-yielding German bunds and other safe-haven euro area bond markets. Indeed, one could argue that the euro is not cheap enough. Thirty-year U.S. Treasurys currently yield 3.07% while 30-year German bunds yield 1.16%, a difference of 191 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.4 The euro got a good clobbering yesterday following the release of the ECB's post-meeting statement, which established a timeline for ending asset purchases by the end of this year but promised no rate hikes for at least another 12 months. We continue to expect EUR/USD to hit 1.15, with a high likelihood that it goes even lower. Lessons From The Nixon Shock We are skeptical of the argument that threatening to raise tariffs is an effective tool for talking down one's currency. It is true that the Nixon Administration imposed an across-the-board 10% tariff in August 1971, which succeeded in forcing America's trading partners to revalue their currencies within the quasi-fixed exchange-rate Bretton Woods system that prevailed at that time. Such an arrangement would be difficult to orchestrate today. For one thing, the U.S. does not have the geopolitical sway that it once did. Moreover, when exchange rates are pegged, one can often revalue a currency to the upside while cutting interest rates (if investors expect a series of revaluations, they would be willing to hold government bonds even if they yielded less than those abroad). In today's world of flexible exchange rates, a country would need to be willing to tighten monetary policy to drive up its currency. Thus, it would get hit on two fronts: From a stronger currency and from higher interest rates. This additional cost to the economy lowers the odds that any country would voluntarily undertake such measures in the hope (probably futile anyway) of placating Trump. In any case, most of the dollar's weakness in the 1970s occurred after the December 1971 Smithsonian Agreement reversed Nixon's tariff hike. What followed was a period of trade liberalization on the back of successive GATT negotiation rounds. U.S. tariffs actually fell more in the 1970s than in the prior two decades (Chart 8). The fact that the dollar weakened during that period had more to do with the Fed, which permitted inflation to get out of hand by allowing real rates to remain in chronically negative territory. The dollar also suffered from the surge in oil prices, which produced a 35% deterioration in the U.S. terms of trade over the course of the decade (Chart 9). Chart 8Two Centuries Of U.S. Tarriffs Chart 9Dollar Weakness In the 1970s: Blame Deteriorating Terms Of Trade And A Dovish Fed It is possible that the Fed will repeat the mistakes of the 1970s, but this is more of a risk for the 2020s than a near-term concern. U.S. real yields have actually risen substantially relative to those abroad since last September (Chart 10). Chart 10The Dollar Is Once Again Responding ##br##To Real Rate Differentials The outcome of this week's FOMC meeting was on the hawkish side. The median number of dots in the newly released Summary of Economic Projections now point to four rate hikes this year, up from three hikes in the March projections. In addition, the Fed increased estimates for both growth and core inflation for this year. The decision to hold press conferences following every FOMC meeting will also give the Fed greater scope to expedite the pace of rate hikes. Investment Conclusions After panicking over every Trump tweet promising more protectionism earlier this year, markets have taken the recent news of escalating trade tensions in stride. Investors presumably think that Trump will water down his rhetoric, as he has periodically done over the past few months. Such a benign outcome is entirely possible. Trump left a fig leaf at the G7 summit in the form of a challenge to other members to eliminate their tariffs in exchange for the U.S. doing the same. Reaching such a deal would not be easy, but incremental progress towards this goal could be achieved. The overall level of tariff barriers within developed countries is already quite low. The U.S. actually stands at the top end of the spectrum -- average U.S. tariffs of 1.6% are double that of Canada, for example -- so the rest of the G7 would be wise to call Trump's bluff and agree to talks to further scale back trade barriers (Chart 11). This could give risk assets some breathing space for the next year or so. Yet, such a rosy outcome is far from guaranteed. Protectionism is popular among American voters, especially among Trump's base (Chart 12). Trump's obsession with the level of the stock market was a constraint on his protectionist rhetoric, but now that investors are content to look the other way, that constraint has loosened. Chart 11Tariffs: Who Is Robbing The U.S.? Chart 12Free Trade Is Not In Vogue In The U.S., And Is ##br##Especially Disliked Among Trump Supporters The fact that Trump's macroeconomic policies are completely at odds with his trade agenda does not help matters. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. The effect of a trade war on the stock market would be grave. Multinational firms have large footprints abroad, the result of decades of investment in global supply chains. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. In light of these risks, we expect to downgrade our recommendation on global equities from overweight to neutral before the end of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Lydia Cox and Kadee Russ, "Will Steel Tariffs put U.S. Jobs at Risk?," EconoFact, February 26, 2018. Steel-consuming industries are defined as those that devote more than 5% of their total costs to steel. 2 Considering that 80% of U.S. currency in circulation consists of $100 bills, it is safe to say that much of this overseas stash of cash belongs to those who acquired it through ill-gotten means. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0191)^30=0.84 today. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Underweight (Upgrade Alert) The narrative for the S&P cable & satellite index this year has been an ongoing (and accelerating) loss of share of the consumer's wallet (second panel) as over-the-top providers continue to steal customers. The subscriber losses in the industry are perhaps best evidenced by the divergence of rising prices and falling revenues (third panel). The reaction has been explosive vertical acquisitions between content providers and delivery; this week's failure of the Department of Justice to block AT&T's bid to acquire Time Warner stands as tacit approval of more of the same. Though it may be counterintuitive, we are softening our stance on the S&P cable & satellite index. Merger mania and fears of a balance sheet blowout have decimated the index's relative performance over the past year (top panel), which is now fully reflected in rock bottom valuations (bottom panel). While more shoes may drop in the bidding wars to come, we think we are very close to the worst being priced in. Accordingly, we are adding an upgrade alert to the S&P cable & satellite index to protect the 16% relative gains we have made since our underweight recommendation earlier this year. The ticker symbols for the stocks in the cable & satellite index are BLBG: S5CBST - CMCSA, CHTR, DISH.
Highlights In line with our House view, we expect the broad USD trade-weighted index (TWIB) to continue to appreciate over the next six to 12 months, as U.S. growth outpaces that of other DMs, and the Fed's pace of rate hikes outpaces that of other systemically important central banks. Ordinarily, this would be bad news for the overall commodities complex. However, most commodity prices disconnected from the U.S. dollar in 2015 - 16. This disconnect produced a not-often-seen positive correlation between commodities and the USD, which remained in place into 2017. Fundamentals are keeping oil and base metals correlations weaker vs. the USD. Precious metals and ags are most vulnerable to a stronger USD. Highlights Energy: Overweight. Cracks in Nigeria's Bonny pipeline system will further delay loadings already curtailed by a force majeure declaration, according to local sources. Elsewhere, the Kingdom of Saudi Arabia (KSA) apparently boosted production ahead of the regularly scheduled OPEC meeting in Vienna on June 22, as mounting losses in Venezuela and U.S. sanctions against Iran loom.1 KSA and Russia are pushing for higher production from OPEC 2.0 ahead of the Vienna meeting. Base Metals: Neutral. Although union negotiators took a conciliatory tone in discussions, contract terms between it and BHP Billiton in Chile's Escondida mine still have not been resolved. Among other things, the union proposed a salary increase of 5% and a $34,000 one-off bonus for workers.2 Precious Metals: Neutral. Gold prices held close to $1,300/oz going into this week FOMC meeting. Ags/Softs: Underweight: The USDA revised down its ending-stocks estimates for corn and soybeans for the 2017/18 and the 2018/19 crop years in its latest WASDE, which was released earlier this week. Feature Chart of the WeekUSD TWIB Vs. Chief Commodity Indices Broadly speaking, commodity prices are negatively correlated with the USD TWIB. The principal indices we follow - the CRB, Bloomberg and S&P GSCI index - all are cointegrated with the USD, i.e., they share a long-term trend, wherein commodity prices rise as the USD falls, and vice versa (Chart of the Week). Ordinarily, we would expect the near-term appreciation of the U.S. dollar to weigh on broad commodity indices' performance. These are not ordinary times. Surprisingly, what holds for these aggregate indices does not hold for individual commodity groups within the indices. We've ranked each commodity by industry group, and found that over the long term - and this is critical - oil and base metals are most sensitive to changes in the USD TWIB, while precious metals and ags are less sensitive. A 1% change in the U.S. dollar index leads to a change in the energy sub-index of the CRB of almost 5%, while a 1% change in the TWIB leads to a change of just under 4% for the base metals sub-index of the CRB. For the precious metals sub-index of the CRB, we would expect to see prices change by just under 3% for every 1% change in the dollar index, while for the ags sub-index of the CRB, broadly speaking, we could expect a change of just under 2.5%.3 USD's Complicated Relationship With Commodities To understand what's driving the broad indices and their component sub-indexes, we ran Granger-causality tests to get a better picture of what's driving what.4 On average, the U.S. dollar drives the broad indices, from a Granger-causality perspective. However, it does not drive the individual commodity sub-indexes in the same manner (Table 1). Table 1USD Vs. Commodities: What's Driving What? We found an interesting relationship between copper and oil: Copper's relationship with oil is stronger than its relationship with the USD - likely because both commodities respond to the same demand factors (e.g., global industrial growth), and that mining and refining copper are energy-intensive processes. We still see a long-term underlying common relationship with the U.S. dollar, but copper is more strongly tied to oil. Bottom Line: We ranked the four main commodity groups with respect to their historical sensitivity to the USD using two distinct metrics. Over the long haul, we found the order from most to least sensitive is (1) Energy, (2) Base Metals, (3) Precious Metals, (4) Ags. USD And Commodities Out Of Whack While most commodity indices exhibit strong and stable negative correlations with the U.S. dollar, many of these relationships were pushed out of their long-term equilibria in 2016, and, importantly, have remained out of whack for an unusually long period (Chart 2).5 In fact, we found most individual commodities and commodity groups haven't converged back to their long-term equilibrium correlation levels with the USD TWIB, and their respective divergences are once again moving higher (Chart 3). Chart 2CRB Sub-Indices Out Of Whack With USD Chart 3Short-Term Correlations Remain In Disequilibrium As we've shown in previous research, commodity prices can remain in disequilibrium with the dollar when important fundamental (supply - demand) shocks dominate price formation.6 Table 2 shows which commodity groups are most out-of-equilibrium since 2016 relative to their long-term historical correlation. Energy, especially oil, and base metals groups are at the top of this list. Despite the fact that both of these groups are the most sensitive to the USD, based on our long-term analysis discussed above, the fact that they remain in disequilibria with the USD suggests the increase in the U.S. dollar we expect over the next 6 months will have a limited impact on these commodities. This leaves ags and, notably, precious metals, most vulnerable to the USD appreciation foreseen in our House view. Table 3 shows how the sensitivities of the different commodity groups vs. the USD TWIB have changed from 2015 to now versus the 2000 to 2015 period preceding it.7 Moreover, we see that in the shorter period between 2015 and now, the base metals and oil sensitivities (in red) are not significant. Economically, this means prices have disconnected from the USD during this period, owing to the overwhelming influence of supply-demand fundamentals on the price-formation process. Table 2Rank Of Rolling Correlation Divergences##BR##In 6-Month Vs. 5-Year Rolling Correlations Table 3Fundamentals Overwhelm##BR##USD's Influence Since 2015 The most plausible explanation for this is base metals and oil markets experienced fundamental shocks over the period - especially since 2016, e.g. OPEC launching a market-share war in 2014 and surging production, followed by the OPEC 2.0 production cuts still in force in the market. In theory, and absent important fundamental (supply-demand) shocks in base metals and energy markets (e.g., a strike at major copper mines or an unexpected outcome at the OPEC 2.0 meeting next week), these correlations should converge back to the long-term equilibrium. However, the speed of convergence is unknown. As long as we observe a disequilibrium in the short-term correlations, we can assume that the disequilibrium will be maintained over the short term. The short-term correlation movements show most of the commodity groups were converging toward equilibrium in recent months, but have since reversed course, particularly oil (Chart 4 and Table 2). Chart 4Short- Vs. Long-Term Correlations Divergence We believe the historic correlation levels between base metals and oil prices and the USD TWIB gradually will be restored. However, a number of factors will have to be monitored in order to determine the timing and the level around which the correlations will stabilize - i.e., close to the 2008 - 2013 levels or to those of the 2000 - 2007 period (Chart 5). We found that the EM/DM business cycle - i.e., the relative performance of EM to DM economies - as well as the shape of the oil forward curve generally can act as mediating factors in restoring the correlations of the USD TWIB and commodity prices.8 The stronger EM economies are relative to DM economies, or the more in contango the oil forward curve is, the more negative the correlations between commodities, especially oil and base metals, and the USD TWIB. Obviously, should the opposite occur, we would expect the weaker correlations to persist, although this might not constitute a complete disequilibrium. The mediating factors we mentioned can diminish or enhance the USD - Commodity correlations, but that does not mean they completely break them down. Chart 5Oil Vs. USD TWIB Correlation Remains Out Of Whack Bottom Line: Commodity prices disconnected from the U.S. dollar in 2015 - 16, which led to a rare environment in which the correlations between the USD TWIB and commodities became positive. Surprisingly, this disconnect remained in place for an extended period, which led us to revise our USD-elasticity ranking of commodity groups. As long as the fundamental shocks in the energy and base metals groups continue to dominate price formation in these markets, precious metals and ags will remain the most vulnerable groups to U.S. dollar appreciation. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "More delays to Nigerian Bonny Light as crude pipeline closes," published by Naija247 in Nigeria on June 11, 2018, and "Saudis Start to Ramp Up Oil Output, Ahead of OPEC Meeting," published by The Wall Street Journal, June 8, 2018. See also BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding to Higher Output; Volatility Set To Rise ... Again," published on March 31, 2018. Available at ces.bcaresearch.com. OPEC 2.0 is the name we coined for the oil-producer coalition led by The Kingdom of Saudi Arabia (KSA) and Russia. 2 Please see "Escondida Union to Copper Investors: Bet on Quick Wage Deal," published by bloomberg.com, June 7, 2018, and "BHP responds to contract proposal from union at Chile's Escondida mine," published by uk.reuters.com on 11 June 2018. 3 These elasticities are the average coefficients for each commodity group we calculated using two different cointegrating regressions - Dynamic Ordinary Least Square and Panel - covering Jan 2000 to now. 4 Granger-causality measures the extent to which changes in one variable cause (or allow one to predict) changes in another variable. This is based on the work of the 2003 Nobel laureate, Clive Granger, who began publishing on this in 1969. Please see "Investigating Causal Relations by Econometric Models and Cross-spectral Methods," Econometrica, Vol. 37, No. 3 (Aug., 1969), pp. 424-438. 5 We make sure the correlations we estimate use cointegrated random variables, which means the empirical results we get provide consistent estimates of actual population correlations. Please see Johansen, Soren (2007), "Correlation, regression, and cointegration of nonstationary economic time series," published by the Center for Research in Econometric Analysis of Time Series at the Aarhus School of Business, University of Aarhus. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "OPEC 2.0 Vs. The Fed," dated February 08, 2018, available at ces.bcaresearch.com. 7 These sensitivities are coefficients in cointegrating regressions, which, given the construction of the regressions, are elasticities. 8 Using threshold regressions, we found the USD impact on BM and energy prices is, on average, weaker when DM stock prices outperform that of EM and when the oil forward curve is backwardated. These two variables act as mediators to the USD-Commodity relationship, and can be used to project the strength of the relationship. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric stop-loss. 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-10 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. * 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 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
Overweight Consumer finance stocks have been mostly range-bound over the past two years following their significant underperformance in the two years prior. We think the trading range is only a pause as the sector girds itself for another step higher. Unemployment claims, the single largest driver of underlying earnings growth, have diverged from the index's performance in the last five years (top panel). At the same time as unemployment claims have been falling, revolving consumer credit has been expanding at an exceptional rate. Following a lull at the end of last year, growth appears to be reaccelerating (second panel). Meanwhile, the consumer continues to look eminently capable of growing their household balance sheet (third panel). Typically, periods of expanding consumer credit see tightening of credit card interest rate spreads; the opposite has been happening in the most recent period as spreads have widened by 100 basis points from their most recent low in 2014 (bottom panel). Further, according to the Fed's most recent senior loan officer survey, a majority of lenders are willing extenders of credit. The upshot is that consumer finance companies should be able to grow more profitably than in the past. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CFINX - AXP, DFS, SYF, NAVI, COF.
Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification