Developed Countries
Highlights The labor market continues to tighten and pressure the Fed. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors. BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. Assessing performance of financial markets and the economy as financial conditions tighten. Feature Chart 1Oil Prices And Breakevens##BR##Moving In Lock Step Oil prices rose last week, U.S. equity prices climbed and credit spreads narrowed. Energy prices surged in the wake of President Trump's withdrawal from the 2015 JCPOA deal with Iran. BCA's Commodity & Energy Strategy team noted that the decision is unambiguously bullish for oil prices.1 Escalating geopolitical risks2 with Iran will add the potential for oil supply losses down the road and hence, add a premium to prices. Venezuelan oil production has been declining for the past two years, sitting at only 1.5 million b/d. The pace of future declines is unknown, but the potential for another steep contraction is worrisome as Venezuela's economic collapse continues and links in the oil export supply chain are breaking down. In light of these factors, BCA expects oil prices to test $90/bbl by the end of year. Importantly, inflation expectations are escalating along with oil prices (Chart 1). Continued upward pressure will have implications for monetary policy, particularly in the U.S. where inflation is approaching the Fed's target. The bottom panel of Chart 1 shows that the correlation between Brent crude and the 10-year Treasury breakeven swaps is positive and rising. BCA's U.S. Bond Strategy service pegs fair value for the 10-year Treasury yield at 3.28%.3 The Fed is poised to raise rates gradually this year and next as the labor market tightens further, pushing up wage inflation. Fed rate hikes will squeeze financial conditions and ultimately trigger the next recession in early 2020. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors of the economy. Meanwhile, liquidity indicators remain generally favorable for financial assets and the U.S. economy. Nonetheless, BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. The March To 3.5% Data from the National Federation of Independent Business (NFIB) in April and the Job Openings and Labor Turnover Survey (JOLTS) in March support our stance that the slack in the U.S. labor market is tightening and will ultimately lead to higher wage inflation. As noted in last week's report,4 the U.S. economy created an average of 208,000 new jobs in the three months ending April and the unemployment rate fell to a new cycle low of 3.9%. Annual wage inflation moderated in April to just 2.6% from a recent high of 2.8% in January. Chart 2 shows that small business owners' compensation plans remained near all-time highs in April. This metric is closely aligned with the wages and salaries component of the Employment Cost Index (ECI) and suggests further acceleration ahead for the ECI (panel 1). Job openings via the JOLTS data also hit a new zenith in March, creating an even wider gap between openings and hires (panel 2). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 3). The stout labor market has lifted the prime age (25-54 years) participation rate. BCA expects that the overall participation rate will remain flat in the next year or so. However, we concur with the Congressional Budget Office that due to demographics, the participation rate will drift lower in the next decade.5 Moreover, the robustness of the labor market is widespread. Charts 3A and 3B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in 9 of the 10 sectors. The exception is the information sector, which includes industries such as newspaper and magazine publishing, broadcasting and telecommunications. Chart 2Labor Market Slack Is Disappearing Chart 3AStrength In The Labor Market... Chart 3B... Is Broad-Based Bottom Line: The U.S. labor market continued to tighten as Q2 began. BCA's stance is that the unemployment rate will fall to a 50-year low of 3.5% by mid-2019.6 The FOMC pegs the longer-term unemployment rate at 4.5%.7 The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. However, BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 3.9%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.8 Stay underweight duration. How High Is High? Chart 4Cyclical Spending Suggests That##BR##Monetary Policy Remains Accommodative The uptrend in cyclical spending suggests that U.S. monetary policy remains accommodative for the time being. Chart 4 shows overall cyclical spending as a share of potential GDP (panel 1) and for sectors most sensitive to the business cycle and interest rates: consumer spending on durables (panel 2), capital spending (panels 3 and 4) and housing (panel 4). All of these metrics are in an uptrend, although the rate of increase has declined during the past few quarters because of slightly weaker consumer spending on durables. In last week's report, we noted that rising rates and tighter financial conditions will not impact household and business spending this year.9 Table 1 shows that since 1960 total cyclical spending as a share of potential GDP has peaked six quarters prior to the onset of a recession. Consistent with our prior research,10 housing reached a zenith several quarters before other sectors. On the other hand, business spending on commercial real estate topped out only a year before a recession. Housing also provides the earliest warning in long economic cycles,11 peaking 14 quarters before the end of an expansion. Overall, cyclical sectors in long expansions crest 10 quarters before the onset of a downturn. Bottom Line: The performance of cyclical segments of the economy suggests that monetary policy is still accommodative. A distinct peak in these sectors will signal that Fed policy has turned restrictive and that long-term rates are close to their cyclical highs. Until then, stay long stocks over bonds and underweight duration. Tightening liquidity and financial conditions are associated with peaks in the cyclical sectors of the economy. Table 1Recession Signals From Cyclical Sectors Of The Economy Liquidity And Financial Conditions While liquidity conditions are accommodative, they are not nearly as abundant as prior to the Lehman event. The October 2017 Bank Credit Analyst Special Report on liquidity12 noted that monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis (GFC), is still a long way from the pre-Lehman go-go years, according to several important indicators such as bank leverage. Moreover, the Fed is in the process of unwinding a massive amount of monetary liquidity provided by its quantitative easing program. The gauges of liquidity have turned restrictive in recent months. Chart 5 shows M2 growth less GDP growth (top panel) along with monetary conditions and world reserves ex gold. Furthermore, the gap between nominal GDP growth and short rates has narrowed this year (Chart 6). Still, GDP growth is outpacing short rates, a sign that monetary liquidity is still present. Chart 5Monetary Liquidity Indicators (I) Chart 6Monetary Liquidity Indicators (II) Balance sheet liquidity for corporations, households and the banking sector remains supportive. The top panel of Chart 7 presents short-term assets-to-total liabilities for the corporate sector. It is a measure of readily available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on their balance sheets. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. The impact of the Tax Cut and Jobs Act of 2017 may partially reverse this trend. Households are also very liquid when short-term assets are compared with income (panel 2). Liquidity is low as a share of individuals' total discretionary financial portfolios, but this is not surprising given extraordinarily unattractive interest rates. In the banking sector, short-term assets as a percentage of total bank credit has climbed in the past decade as banks were forced to hold more liquid assets in the wake of the 2007-2009 financial crisis (Chart 8). Chart 7Balance Sheet Liquidity Chart 8Banking Sector Liquidity Charts 9 and 10 show market liquidity in the U.S. equity and high-yield markets. For the equity market, we present the one-year moving average of trading volume divided by shares outstanding or share turnover to get a sense of relative liquidity between firms (Chart 9). This measure has improved in recent years, but remains compressed vis-a-vis pre-crisis levels. BCA's Equity Trading System favors firms with lower liquidity, since investors pay a premium for liquidity.13 Liquidity in the high-yield market has recovered in recent years, but flows into high-yield bond funds turned negative in mid-2017 (Chart 10, panels 1 and 2). Nonetheless, the default-adjusted junk spread remains below its long-term average (panel 3). BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.14 Chart 9Equity Market Liquidity Chart 10High Yield Bond Market Liquidity Funding liquidity - as measured by primary dealers' securities lending - has recovered from financial crisis lows, but has not reached pre-crisis highs (Chart 11, panel 1). Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. The uptrend in margin debt remains in place (panel 2). The steep escalation in this direct measure of funding liquidity is less impressive when compared with the S&P 500's market cap. Bank's lending standards for C&I loans are another measure of funding liquidity (Chart 12). These surveys reflect bank lending standards on loans to the household or corporate sectors. Nonetheless, a financial institution's appetite for lending for the purposes of securities purchases is highly correlated. Lending standards eased in 2017 and in early 2018, but they are not as loose as they were earlier in this cycle or in the pre-crisis period (2005-2007). Chart 11Funding Liquidity:##BR##Securities Lending And Margin Debt Chart 12Funding Liquidity:##BR##Bank Lending Standards Perspective On Liquidity And Financial Conditions BCA expects that both monetary and financial conditions will constrict in the next year as inflation moves through the Fed's 2% target and the FOMC gradually boosts rates in the next 12 months. A stronger dollar and higher bond yields will contribute to the tightening, but higher equity prices are an offset. Chart 13, Appendix Chart 1, and Tables 2 and 3 show BCA's MI versus key U.S. financial assets and commodities, and U.S. economic variables. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Moreover, BCA's stocks-to-bonds ratio rises, investment-grade and high-yield corporate bonds outperform Treasuries. However, oil prices struggle in this environment (Chart 13 and Table 2). Chart 13Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Table 2Performance Of Risk Assets When Monetary Indicator Is Above Zero Table 3Performance Of Risk Assets When Monetary Indicator Is Below Zero When MI is below zero, on the other hand, economic performance is mixed. GDP growth, cyclical spending as a share of GDP, and employment tend to peak when the MI is decelerating, but recessions rarely occur when the MI is negative (Appendix Chart 1, panels 2, 3 and 4). Core inflation often peaks when the MI is above zero (not shown). However, the MI is sending a negative signal because interest rates have increased and credit growth has slowed. Table 3 indicates the performance of U.S. financial assets when the MI is below zero. We used the periods in which the MI was persistently below zero to avoid false signals. Note that the average and median returns for most asset classes in Table 3 (MI below zero) are well below those in Table 2 (MI above zero). Notable exceptions are oil and the dollar, which strengthen when the MI is below zero. S&P 500 earnings growth struggles during this episodes. Chart 14, Appendix Chart 2, and Tables 4 and 5 present financial conditions versus key U.S. financial assets and commodities, and U.S. economic variables. BCA expects the financial conditions index (FCI) to decline further into negative territory in the next few years. U.S. equities and credit tend to perform better when the FCI rises (Table 4) rather than when it falls (Table 5). However, when it does fall, gold and oil are stronger. Chart 14Risk Assets When Financial Conditions Tighten Table 4Performance Of Risk Assets When Financial Conditions Are Easing Table 5Performance Of Risk Assets When Financial Conditions Are Tightening Moreover, we note that GDP growth and cyclical spending as a share of GDP often peak when FCI drops. Employment and inflation are mixed at best when the FCI decelerates (Appendix Chart 2). Bottom Line: The U.S. economy is growing above its long-term potential, the labor market is tightening and inflation is at the Fed's target but poised to move higher next year. The Fed will increase rates to cool the overheating economy. Therefore, liquidity and financial market conditions will deteriorate further in the next year as Treasury yields increase and the dollar climbs in tandem with a more aggressive Fed. Stay overweight stocks versus bonds for now, but look to pare back exposure later this year. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published May 9, 2018. Available at nrg.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," published March 28, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Coming To Grips With Gradualism," published May 9, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Housing And Consumer Sectors," published May, 7 2018. Available at usis.bcaresearch.com. 5 https://www.cbo.gov/system/files/115th-congress-2017-2018/workingpaper/53616-wp-laborforceparticipation.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...," published March 26, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics," published April 17, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "2018: Synchronized Global Growth," published December 4, 2017, and "Drives U.S. Economy And Markets," published December 4, 2017. Both available at usis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, published November 24, 2016. Available at bca.bcarearch.com. 12 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," published October 2017. Available at bca.bcarearch.com. 13 Please see BCA Research's Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach to Bottom-Up Stock Picking," published December 3, 2015. Available at ets.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Coming To Grips With Gradualism," published May 8, 2018. Available at usbs.bcaresearch.com. Appendix Appendix Chart 1The Economy When Monetary Indicator Is Below Zero Appendix Chart 2The Economy When Financial Conditions Are Tightening
Highlights Tinbergen's rule says that the successful implementation of economic policy requires there to be at least as many "instruments" as "objectives." Policymakers today are increasingly discovering that they have too many of the latter but not enough of the former. By turning fiscal policy into a political tool rather than one for macroeconomic stabilization, the U.S. has found itself in a position where it can either meet President Trump's goal of having a smaller trade deficit or the Fed's goal of keeping the economy from overheating, but not both. In the near term, we expect the Fed's priorities to prevail. This will keep the dollar rally intact, which could spell bad news for some emerging markets. Longer term, the Fed, like most other central banks, must confront the vexing problem that the interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Getting inflation up a bit may be one way to mitigate this problem, as it would allow nominal interest rates to rise without pushing real rates into punitive territory. This suggests that the structural path for bond yields is up, consistent with our thesis that the 35-year bond bull market is over. Feature Constraints And Preferences The late Jan Tinbergen was one of the great economists of the twentieth century. Often referred to as the father of econometrics, Tinbergen and Ragnar Frisch were the first people to be awarded the Nobel Prize in Economics in 1969. One of Tinbergen's most enduring contributions was his demonstration that the successful implementation of economic policy requires there to be at least as many "instruments" (i.e., policy tools) as "objectives" (i.e., policy goals). Just like any system of equations can be "overdetermined" or "underdetermined," any set of "policy functions" may have a unique solution, many solutions, or no solution at all. The first outcome corresponds to a situation where there are as many instruments as objectives, the second where there are more instruments than objectives, and the third where there are fewer instruments than objectives. In essence, the Tinbergen rule is a mathematical formulation of the idea that it is hard to hit two birds with one stone. The Tinbergen rule often comes up in macroeconomics. Consider a country that wants to have a low and stable unemployment rate (what economists call "internal balance") and a current account position that is neither too big nor too small ("external balance"). This amounts to two objectives, which can be realized with the right mix of two instruments: Monetary and fiscal policy. As discussed in greater detail in Appendix A, the classic Swan Diagram, named after Australian economist Trevor Swan, shows how this is done. Chart 1Spain: The Cost Of The Crisis If the country wants to add a third objective to its list of policy goals, it has to either give up one of its existing objectives or find an additional policy instrument. Suppose, for example, that a country wants to move to a pegged exchange rate. It can either forego monetary independence, or introduce capital controls in order to allow domestic interest rates to deviate from the interest rates of the economy to which it is pegging its currency. This is the logic behind Robert Mundell's "Impossible Trinity," which states that an economy cannot simultaneously have all three of the following: A fixed exchange rate, free capital mobility, and an independent central bank. It can only choose two items from the list. Peripheral Europe learned this lesson the hard way in 2011. Not only did euro membership deny Greece, Italy, Spain, Portugal, and Ireland access to an independent monetary policy and a flexible currency, but the ECB's failure under the bumbling leadership of Jean-Claude Trichet to backstop sovereign debt markets necessitated fiscal austerity at a time when these economies needed stimulus. These countries were left with no effective macro policy instruments whatsoever, thus putting them at the complete mercy of the bond vigilantes, German politicians, and the multilateral lending agencies. The only thing they could do was incur a brutal internal devaluation to make themselves more competitive. Even for "success stories" such as Spain, the cost in terms of lost output was over one-third of GDP (Chart 1) - and probably much more if one includes the deleterious effect on potential GDP growth from the crisis. Trump Versus Tinbergen One might think that the U.S. is largely immune from Tinbergen's rule. It is not. President Trump and the Republicans in Congress have rammed through massive tax cuts and spending increases (Chart 2). By doing so, they have turned fiscal policy into a political tool rather than one for macroeconomic stabilization. In and of itself, that is not an insuperable constraint since monetary policy can still be used to achieve internal balance. The problem is that Trump has also declared that he wants external balance, meaning a much smaller trade deficit. Now we have two policy objectives (full employment and more net exports) and only one available instrument: Monetary policy. Chart 2The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline This puts the Fed in a bind. If the Fed hikes rates aggressively, this will keep the economy from overheating, thus achieving internal balance. But higher rates are likely to bid up the value of the dollar, leading to a larger trade deficit. On the flipside, if the Fed drags its feet in raising rates, the dollar could weaken, resulting in a smaller trade deficit and moving the economy closer to external balance. However, the combination of low real interest rates, a weaker dollar, and dollops of fiscal stimulus will cause the unemployment rate to fall further, leading to higher inflation. Investor uncertainty about which path the Fed will choose may be partly responsible for the gyrations in the dollar of late. At least for the next year or so, our guess is that the Fed's independence will keep it on course to raise rates more than the market is currently pricing in, which will result in a stronger dollar. Beyond then, the picture is less clear. This is partly because the increasing politicization of society may begin to affect the Fed's behavior. History suggests that inflation tends to be higher in countries with less independent central banks (Chart 3). But it is also because Tinbergen's ghost is likely to make another appearance, this time in a wholly different way. Chart 3Inflation Tends To Be Higher In Countries Lacking Independent Central Banks The Fed's "Other" Mandate Officially, the Fed has two mandates: ensuring maximum employment and stable prices. In practice, this "dual mandate" can be boiled down to a single policy objective: Keeping the unemployment rate near NAIRU, the so-called Non-Accelerating Inflation Rate of Unemployment. The Fed has sought to meet this objective through the use of countercyclical monetary policy: Easing monetary policy when output falls below potential and tightening it when the economy is at risk of overheating. So far, so good. The problem is that the Fed, like most other central banks, is being asked to take on another policy objective: ensuring financial stability. Here's the rub though: The interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Excessively low rates are a threat to financial stability. A decline in interest rates pushes up the present value of expected cash flows; the lower the discount rate, the more of an asset's value will depend on cash flows that may not be realized for many years. This tends to increase asset market volatility. In addition, borrowers need to devote a smaller share of their incomes towards servicing their debt obligations when interest rates are low. This tends to increase debt levels. From The Great Moderation To The Great Intemperance Starting in the 1990s, far from entering an era which policymakers once naively referred to as the "Great Moderation," it is possible that the world entered a precarious period where the only way to generate enough spending was to push down interest rates so much that asset bubbles became commonplace. In a world where central bankers have to choose between insufficient demand and recurrent asset bubbles, the idea of a "neutral rate" loses much of its meaning. By definition, the neutral rate is a steady-state concept. However, if the interest rate that produces full employment and stable inflation is so low that it also generates financial instability, how can one possibly describe this interest rate as "neutral"? Faced with the increasingly irreconcilable twin objectives of keeping the unemployment rate near NAIRU and putting the financial system on the straight and narrow, central bankers have reached out for a second policy instrument: macroprudential regulations. So far, however, the jury is still out on whether this tool is sufficiently powerful to prevent future financial crises. Politics has a bad habit of getting in the way of effective regulation. President Trump and the Republicans have been looking for ways to water down the Dodd-Frank Act. The Democrats are complaining that banks and other financial institutions are not doing enough to channel credit to various allegedly "underserved" groups. Faced with such political pressure, it is not clear that regulators can do their jobs. If You Can't Raise r-Star, Raise i-Star What is the Fed to do? One possibility may be to aim for somewhat more inflation. A higher inflation target would allow the Fed to raise nominal policy rates while still keeping real rates low enough to maintain full employment. Higher nominal rates would impose more discipline on borrowers and discourage excessive debt accumulation. Higher inflation would also reduce the likelihood of reaching the zero bound again, while also limiting the economic fallout of asset busts. The Case-Shiller 20-City Composite Index declined by 34% in nominal terms and 41% in real terms between April 2006 and March 2012. Had inflation averaged 4% over this period rather than 2.2%, a 41% decline in real home prices would have corresponded to a less severe 26% decrease in nominal prices, resulting in fewer underwater mortgages. Finally, higher inflation would allow countries to increase nominal income growth. In fact, higher inflation may be the only viable way to reduce debt-to-GDP ratios in a high-debt, low-productivity growth world. Investment Conclusions We advised clients on July 5, 2016 that we had reached "The End Of The 35-Year Bond Bull Market." As fate would have it, this was the exact same day that the 10-year yield reached an all-time closing low of 1.37%. Bond positioning is very short now (Chart 4), so a partial retracement in yields is probable. Cyclically and structurally, however, the path for yields is up. Much like what transpired between the mid-1960s and the early 1980s, investors should expect global bond yields to reach a series of "higher highs" and "higher lows" with each passing business cycle (Chart 5). Chart 4Traders Are Short Treasurys Chart 5A Template For The Next Decade? Just as was the case back then, the Fed is now behind the curve in raising rates. The three-month and six-month annualized change in core PCE has reached 2.6% and 2.3%, respectively. Yesterday's CPI report was softer than expected, but the miss was almost entirely due to a deceleration in used car prices and airfares, both of which are likely to be temporary. Meanwhile, the labor market remains strong. The unemployment rate is down to 3.9%, just slightly above the 2000 low of 3.8%. According to the latest JOLTS survey released earlier this week, there are now more job openings than unemployed workers, the first time this has happened in the 17-year history of the survey (Chart 6). Faced with this reality, the Fed will keep begrudgingly raising rates until the economy slows. Right now, the real economy is not showing much strain from higher rates. The cyclical component of our MacroQuant model, which draws on a variety of forward-looking economic indicators, moved back into positive territory this week. Both the housing market and capital spending are in reasonably good shape (Chart 7). Chart 6There Are Now More Vacancies Than Jobseekers Chart 7Higher Rates Have Not (Yet) Slowed The Economy The U.S. financial sector should also be able to weather further monetary tightening. Corporate debt has risen, but overall U.S. private-sector debt as a percent of GDP is still 18 percentage points lower than in 2008 (Chart 8). Lenders are also more circumspect than they were before the Great Recession. For example, banks have been tightening lending standards on credit and automobile loans, which should reverse the increase in delinquency rates seen in those categories (Chart 9). Chart 8U.S. Private Debt Still Below Pre-Recession Levels Chart 9Lenders Are More Circumspect These Days Resilience to Fed tightening may not extend to the rest of the world, however. Following the script of the late 1990s, it is likely that the combination of higher U.S. rates and a stronger dollar will cause some emerging markets to fall out of bed before U.S. financial conditions have tightened by enough to slow U.S. growth (Chart 10). This week's turbulence in Turkey and Argentina may be a sign of things to come. For now, investors should underweight EM assets relative to their developed market peers. Chart 10Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com APPENDIX A The Swan Diagram The Swan Diagram depicts four "zones of economic unhappiness," each one representing the different ways in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). A rightward movement along the horizontal axis represents an easing of fiscal policy, whereas an upward movement along the vertical axis represents an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order keep the unemployment rate stable. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. To bring imports back down, the currency must weaken. Any point to right of the internal balance schedule represents overheating; any point to the left represents rising unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Appendix Chart 1Four Zones Of Unhappiness Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Underweight (High Conviction) News of a renewed attempt at a merger between Sprint and T-Mobile has weighed heavily on shares in the S&P telecom services index. Shares sold off on fears that a mightier competitor with the heft to invest in a 5G network would continue the price deflation of the past several years, which has only recently started to turn a corner (second panel). It has only been three months since we downgraded the S&P telecom services index to underweight and added it to our high-conviction list. A combination of negative headlines and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel) has meant that our trade has racked up an impressive 13.5% gain versus the broad market in a short time. While S&P telecom services remains a high-conviction underweight, such rapid gains are likely unsustainable, particularly in the context of already-deeply discounted valuations (bottom panel). Bottom Line: Stay underweight the telecom services index. From a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy.1 The ticker symbols for the stocks in this index are: BLBG: S5TELS - T, VZ, CTL. 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.
Underweight In line with our renewed focus on balance sheets as a measure of risk in our portfolio positioning (please see this week's Special Report for more details), we have applied the same rigor to our size bias. With elevated debt levels waving a red flag, today we are acting on our downgrade alert and recommend a large over small cap bias. Over the past decade, the Goldman Sachs weak/strong equity baskets share price ratio has moved in tandem with the small/large share price ratio (SLR, top panel). However, a large and exploitable gap has opened recently that will likely narrow via a convergence lower in the SLR. Respective net debt-to-EBITDA ratios corroborate this downbeat relative indebtedness backdrop, which have seen small caps binging on debt (middle panel); a resulting widening relative equity risk premium should precipitate a decline in small caps relative to their large cap peers. When the net debt-to-EBITDA ratio is expressed as a year-over-year change, it is an excellent leading indicator of relative share price momentum (bottom panel); currently, the signal is crystal clear: over-levered small caps appear destined to underperform better capitalized large cap stocks. Bottom line: We are executing our downgrade alert and moving to a large over small cap preference.
Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The big danger of higher bond yields is to the $380 trillion edifice of global risk-assets, rather than to the global economy per se. Buy a small portfolio of 30-year government bonds, given that higher bond yields are now hurting equities and 30-year yields are close to resistance levels. The ongoing drama of Italian politics is an irritation, rather than an existential risk to the euro area, as long as Italian populists correctly focus their fire on EU fiscal rules rather than the single currency. Nevertheless, we prefer France's CAC over Italy's MIB and Spain's IBEX, given the latter markets' outsize exposure to banks, a sector in which we remain underweight. Feature When travellers from the U.K. find themselves in Continental Europe or the U.S. they frequently make a potentially fatal error. Trying to cross a busy street, they look right instead of left... Your author has made this error several times and lived to tell the tale, but there is an important moral to the story. However carefully you look, you won't spot the oncoming truck if you are looking in the wrong direction! Chart of the WeekEquities And Bonds Are Both Offering A Paltry 2% Look At the Markets, Not The Economy The global long bond yield is up around 60bps from the lows of last September, and it would be natural to ask if this poses a danger to the economy. Credit sensitive economic sectors are understandably feeling a headwind, and global growth has indisputably decelerated (Chart I-2). Yet there is no sense of an oncoming truck. Chart I-2Credit Sensitive Sectors Are Feeling A Headwind But are we looking in the wrong direction? While higher bond yields do not yet threaten the global economy, the big danger is to the $380 trillion edifice of global risk-assets.1 In the space of a few weeks, the correlation between bond yields and equities has suddenly and viciously reversed. When the 10-year T-bond yield was below 2.65%, the correlation was a near perfect positive, r = +0.9 (Chart I-3) but above 2.85%, it has flipped to a near perfect negative, r = -0.8 (Chart I-4). Chart I-3Below A 2.65% T-Bond Yield, Equities And##br## Bond Yields Were Positively Correlated Chart I-4Above A 2.85% T-Bond Yield, Equities And ##br##Bond Yields Have Been Negatively Correlated In 2000, 2008 and 2011, the right direction to look was at the financial markets. Recall that it was instabilities in the financial markets - the bursting of the dot com bubble, the mispricing of U.S. subprime mortgages, and the widening of euro area sovereign credit spreads - that spilled over into economic downturns. In any case, for investment strategy, whether such financial instabilities do or do not spill over into the real economy is a secondary concern. The primary concern must always be to identify financial market vulnerabilities - and opportunities. Rich Valuations Are In A Precarious Equilibrium The single most important determinant of an investment's long term return is not the investment's cash flows per se, it is the price that you pay for the cash flows. This is the fundamental lesson of investment. An investment's cash flows might be growing strongly, but if you overpay for the cash flows - for example, in a bubble - you will end up with a negative return. Conversely, cash flows might be collapsing, but if you buy them at an overly depressed price, you will end up with a positive return. It turns out that the long term prospective return from most investments is well-defined. For government bonds, it is the yield to maturity;2 for equities and other risk-assets it is empirically well-defined by the starting valuation, which tends to be an excellent predictor of the prospective long term return (Chart I-5). Chart I-5World Equities Are Priced To Generate 2% A Year For the long term prospective return from bonds, the main determinant is central bank policy, and specifically the expected path for interest rates. For the long term prospective return from equities, the main determinant is the return that the market demands relative to that on offer from bonds. What establishes this relative return? The answer is relative riskiness, specifically the potential for short term losses versus short term gains, technically known as negative skew. Investors hate negative skew - the potential to experience larger short term losses than gains. Hence, investors demand relative returns that are commensurate with the investments' relative negative skews. This brings us to the crux of the matter. At low bond yields, bonds become much more risky: their returns take on negative skew. Intuitively, this is because the lower bound to interest rates forces a very unattractive asymmetry on bond returns: prices can fall a lot, but they can no longer rise a lot. At a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-6 and Chart I-7). Chart I-6At A 2% Bond Yield, 10-Year Bonds Have##br## The Same Negative Skew As Equities... Chart I-7...So At A 2% Bond Yield, Equities ##br##Must Also Offer A 2% Return Right now, the negative skews on bonds and equities are roughly the same, so investors are accepting roughly the same long term return from global equities as they can get from global bonds - a paltry 2% (Chart of the Week). This justifies an equity valuation as rich as at the peak of the dot com bubble. The trouble is that the valuation justification for $380 trillion of global risk-assets would crumble if the bond yield were to rise meaningfully. But which bond yield? As asset-classes tend to move as global rather than regional assets, the yield that matters is the global long bond yield. Given the large spread in yields across major bonds, a global yield of 2% equates to around 3% in the U.S. and 1% in Europe. This may explain why these are the yield levels at which the correlation between bond yields and equities has suddenly and viciously reversed. This brings us to the investment opportunity: 30-year government bonds. In recent years, 30-year yields have failed to sustain breaks through upper bounds: 3.2% for T-bonds; 2.0% for U.K. gilts; 1.4% for German bunds; and 0.9% for JGBs. Indeed, looking at these yields since 2015 it is hard to discern a bear market in 30-year government bonds (Charts I-8- I-11). Chart I-8Resistance At 3.2% Chart I-9Resistance At 2.0% Chart I-10Resistance At 1.4% Chart I-11Resistance At 0.9% With higher bond yields now hurting equities, and 30-year yields close to resistance levels, it is a good time to buy a small portfolio of 30-year government bonds. What Unites Italy With Japan? Italy and Japan are the only two major economies in which private indebtedness is considerably less than public indebtedness (Chart I-12 and Chart I-13). In the case of Italy, the very low private indebtedness means that its total indebtedness - as a share of GDP - is actually less than that in the U.K., France, Spain and Sweden. Chart I-12Private Indebtedness Is Less Than ##br##Public Indebtedness In Italy... Chart I-13...And In ##br##Japan The other thing that unites Italy with Japan is that their banking systems were left undercapitalised and in a 'zombie' state for years. Which, to a large extent, explains why private indebtedness has been declining in both economies. When somebody in the private sector pays down debt, say €100, and the banking system does not reallocate that €100 to a new private sector borrower, aggregate demand will contract by €100. To prevent this demand recession, the government must step in to borrow and spend the €100. Moreover, because the private sector is deleveraging, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. Instead, government borrowing and spending turns out to be a very sensible economic policy. On this basis, Japan countered its aggressive private sector deleveraging with equally aggressive public sector leveraging and thereby kept its economy motoring along. By contrast, Italy had its hands tied by the EU fiscal compact - which mistakenly looks at public indebtedness in isolation rather than in combination with private indebtedness. Hence, the Italian government was prevented from recapitalizing its banking system, and the Italian economy stagnated for a decade (Chart I-14 and Chart I-15). Chart I-14The Italian Government Was Prevented ##br##From Recapitalising The Banks... Chart I-15...And The Italian Economy ##br##Stagnated For A Decade In this sense, the populist parties in Italy - The League and 5 Star Movement - have correctly identified that Italy's problem is not the euro per se, but the EU's fiscal dogma. Both parties have dropped calls for a referendum on Italy's membership of the euro area, but have doubled down on their intentions to ignore the EU's misguided fiscal rules, such as the 3 per cent limit on budget deficits. As long as Italian populists correctly focus their fire on EU rules rather than the single currency, investors should view the ongoing drama of Italian politics as an irritation, rather than an existential risk to the euro area. Nevertheless, for the time being, we prefer France's CAC over Italy's MIB and Spain's IBEX. This is less a function of politics, and more a function of the latter markets' outsize exposure to banks, a sector in which we remain underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Global equities and high yield and EM debt is worth around $160 trillion and global real estate is worth $220 trillion. 2 Assuming no default risk and no reinvestment risk. Fractal Trading Model* This week, we note that SEK/EUR is at a key technical turning point, and due a countertrend rally. As we already have a long SEK/GBP position open, we are not doubling up with SEK/EUR. In other trades, we are pleased to report that long USD/Chilean peso hit its 2.7% profit target, and is now closed. This leaves us with four open positions. 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-16 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
Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. 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
The S&P packaged foods index has enjoyed a solid Q1 earnings season; results have bested forecasts, leading to some of the highest positive earnings revisions of the past decade (top panel). Robust demand growth, both domestic and international, combined with resilient pricing power (second panel) have pushed sales higher, while costs have been mostly contained. The market has looked through the results to some clouds on the horizon and taken the index down with it. First, food commodities, like nearly all commodity groups, are seeing prices rise; this takes time to filter through earnings, but eventually profits will feel the pinch. More importantly, recent U.S. dollar appreciation will likely crimp sales in the key export market (third panel), as well as sap foreign earnings growth via translation. While some caution is warranted with the headwinds facing the industry, the massive valuation de-rating the index has seen (bottom panel) seems to be an excessive overreaction, particularly in the context of the healthy demand backdrop. Accordingly, we reiterate our outperform recommendation. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, HSY, CAG, SJM, MKC, CPB, HRL.