Developed Countries
Underweight This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. Cruise line operators' margins have climbed to 10-year highs (second panel), justifying soaring stock prices. Profit gains have come on the back of improving passenger growth and constrained capacity i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum further margin gains of this magnitude seem doubtful. The outlook is even less bright for hotels as cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (third panel). Hoteliers are trying to compensate for low prices with huge capacity additions. Our S&P hotels, resorts and cruise lines EPS model does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance, pointing to significant relative declines vis-à-vis the S&P 500 (bottom panel). Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. Take some chips off the table and reduce exposure to the S&P hotels, resorts & cruise lines index to underweight. Please see yesterday's Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5HOTL- MAR, CCL, RCL, HLT, WYN.
Highlights Duration: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Fed Balance Sheet: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Feature Yields bounced back strongly last week, driven by a combination of easing flight-to-safety flows and a reasonably strong August CPI report. Even so, the bond market remains priced for an environment where inflation will never return to the Fed's 2% target, no matter the pace of economic growth. It should therefore not be shocking that yields are quick to spring higher on any evidence that core inflation might re-gain its cyclical uptrend (Chart 1). As we have previously written,1 we anticipate that core inflation will soon respond to above-trend growth and resume its modest cyclical uptrend. It is therefore worth considering whether last week's August CPI report represents a step in that direction or whether it should be written off as an outlier. After digging into the report's details we conclude that while it was probably stronger than we should expect going forward, it also suggests that core inflation is poised to put in a bottom. A Bottom In Core Inflation? Month-over-month core CPI increased 0.248% in August, an annualized pace of 3.02%, and the annualized 3-month rate of change rose back above the 12-month growth rate (Chart 2). This often signals a near-term trend reversal. Chart 1Very Sensitive To Inflation Chart 2Core Inflation By Major Component Shelter inflation jumped higher in August from 3.18% year-over-year to 3.30%. But our model suggests that this uptrend will not persist (Chart 2, panel 2). Notably, the increase in shelter inflation was concentrated in the Houston/Galveston/Brazoria area and as such reflects the one-off impact of Hurricane Harvey. The bottom line is that the positive August number should be considered an outlier. The underlying trend remains one of decelerating shelter inflation. Chart 3Ignore CPI Medical Care In contrast, year-over-year core goods prices decelerated in August, but this deceleration is equally unsustainable. The recent depreciation of the U.S. dollar and surge in non-oil import prices suggest that core goods inflation is poised to increase (Chart 2, panel 3). We expect accelerating core goods prices to offset decelerating shelter prices during the next few months. In the longer-run, neither shelter nor core goods will be sustainable drivers of inflation. Shelter has already rolled over, and core goods inflation will do the same once the dollar reverses its downtrend. For overall core inflation to sustainably return to the Fed's 2% target, core services inflation (excluding shelter and medical care) must be the main source of price pressure. Historically, this component of inflation is the most tightly linked to wage growth (Chart 2, bottom panel), and it has fallen precipitously so far this year. In August, however, year-over-year core services inflation (excluding shelter and medical care) ticked higher from 1.18% to 1.40%. While this is a positive sign, we will need to see further strength in this component to be certain that the downtrend in core inflation has turned. Some pundits have pointed to the steep decline in medical care CPI inflation as an additional deflationary force, but this is a red herring (Chart 3). In the CPI basket, medical care includes only consumers' out of pocket healthcare expenses. It does not include spending by the government on households' behalf, which is included in the Fed's target PCE inflation measure. Unlike CPI medical care, PCE medical care inflation has seen only a mild downturn and should move higher in August based on the most recent PPI numbers (Chart 3, panel 3). The bottom line is that the downtrend in CPI medical care inflation represents nothing more than a convergence between CPI and PCE inflation. Since the Fed targets PCE inflation, falling CPI medical care inflation can be safely ignored. The Fed's Reaction The Fed has already sent a strong signal that there will be no rate hike at this week's meeting, but that it will announce the run-off of its balance sheet (see next section). Our view has been that if inflation shows some signs of rebounding, the Fed will deliver another rate hike in December. The market appears to have taken a similar view and, on the strength of last week's CPI report, is now discounting a 51% chance of another rate hike this year. Last week's CPI report was probably strong enough to ensure that the median FOMC forecast will still call for one more hike this year when the revised forecasts are released tomorrow. However, we suspect that stronger inflation will need to persist for the next few months in order for that hike to be delivered on time. The reading from our Fed Monitor2 underscores how close a call another rate hike is at the moment (Chart 4). The monitor remains in "tighter money required" territory, but only faintly so. Notably, the economic growth and financial conditions components of the monitor both suggest that higher rates are required, but the inflation component remains below zero. This supports the notion that any sign of stronger inflation makes the case for further rate hikes a slam dunk. Chart 4A Close Call For The Fed Bottom Line: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Five Questions About The Fed's Balance Sheet As was mentioned above, the Fed appears set to announce that it will cease the reinvestment of its bond holdings, meaning that its balance sheet will finally start to shrink. In all likelihood this announcement will come in tomorrow's FOMC statement. To recap, here is what we already know about how the plan will proceed: The Fed will cease the reinvestment of Treasuries and MBS at the same time. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. These caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Question 1: How Long Will It Take? To answer this question we must first recall that the Fed does not target a specific level of assets on its balance sheet. Rather, it is the amount of bank reserves in the system (a liability on the Fed's balance sheet) that is the crucial variable for the economy. Bank reserves are the single biggest liability on the Fed's balance sheet, but the amount of currency in circulation is the second biggest. As of last Wednesday, bank reserves totaled $2.4 trillion and currency in circulation totaled $1.6 trillion. The amount of currency in circulation also increases as the economy grows. This means that during normal times the Fed must increase its asset holdings in line with the amount of outstanding currency just to keep the level of bank reserves constant. In other words, even if the Fed allows bank reserves to fall all the way to zero, it will still carry a larger balance sheet than it did prior to the start of QE because of the rising amount of currency in circulation. We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period. Together, as a rough starting point, we have suggested that the necessary amount of excess reserves could be in a range of $400 billion to $1 trillion. Coupled with uncertainty about the likely growth in other factors, such as currency outstanding, this implies a normalized balance sheet size of, perhaps, $2.4 trillion to $3.5 trillion in the early 2020s.3 In our estimates we have assumed that bank reserves will level-off once they reach $650 billion, considerably above levels maintained prior to the financial crisis. Bank reserves averaged $20 billion between 2000 and 2007. There are two main reasons why the Fed will favor a higher level of reserves. The first was also stated in President Dudley's speech: Having managed the System Open Market Account during the financial crisis - a period during which the demand for reserves was very volatile - I very much favor a floor-type system. It is much easier to manage on a day-to-day basis. A "floor system" means that the Fed controls the overnight rate by paying interest on excess reserves and conducting reverse repos with the securities on its balance sheet. This is the system currently in use, and it requires a glut of reserves in the banking system. Prior to the financial crisis, the Fed used a "corridor system" to control interest rates. This system required the Fed to transact in the interbank market to manage interest rates, and it required a dearth of reserves.4 The second reason is that the demand for safe short-maturity investment vehicles has been steadily increasing for at least the past fifteen years, largely due to rising cash balances on corporate balance sheets. Prior to the financial crisis this demand was intermediated through the repo market, but now that repo has mostly gone away, that cash is sitting on deposit at the Fed in the form of reserves (Chart 5). With all this demand, if the Fed tries to remove too many reserves from the banking system it could have difficulty keeping a floor under interest rates. That is, unless some other investment vehicle is supplied to mop up the rising demand for safety. In this regard, T-bills would be the most likely candidate, and fortunately, with T-bills at multi-decade lows as a percentage of the outstanding funding mix (Chart 6), there is ample room for the Treasury to increase bill supply. In short, the secular uptrend in demand for safe short-maturity financial assets means that going forward either: (i) the Fed will have to maintain a greater level of reserves in the banking system, (ii) the Treasury will have to increase the supply of T-bills, or (iii) some combination of the two. With all that in mind, let's answer the initial question of how long the Fed will allow its balance sheet to shrink. Our projections are shown in Chart 7, and make the following assumptions: Chart 5Rising Demand For Safe Short-Dated Assets Chart 6T-Bill Issuance Has Room To Rise Chart 7Fed Balance Sheet Projections Balance sheet run-off begins October 1, 2017 Bank reserves level-off at $650 billion. At that point, the Fed will continue to allow MBS to run off its balance sheet, but will start buying Treasuries to keep reserves stable. MBS will run off at a pace of $15 billion per month, before considering the caps.5 Currency in circulation will grow at a pace of 4.5% per year. Under these assumptions, we estimate that bank reserves will reach the target level of $650 billion in June 2021. At that point, the Fed's securities holdings will total $2.9 trillion - down from the current $4.3 trillion - and the Fed will have to start buying Treasuries to keep reserves stable and compensate for the continued run-off of MBS. Question 2: What Does This Mean For Bond Supply? To compensate for balance sheet run-off, The Treasury will have to increase issuance by $217 billion in 2018, $249 billion in 2019 and $182 billion in 2020 (Chart 8). Then, in 2021 and beyond, the Fed will once again start removing Treasury supply from the market as it stabilizes reserve balances. We estimate that an extra $150 billion of MBS supply will also hit the market in 2018, but we will save a discussion of the impact on MBS spreads for a future report. Chart 8Fed Starts Buying Again In 2021 The form in which this extra issuance will reach the marketplace is a question for the Treasury department. Officially, the Treasury has said: Treasury will likely respond to the additional borrowing needs associated with SOMA redemptions by increasing both Treasury bill and Treasury nominal coupon auction sizes, beginning with bills and then coupons, as appropriate.6 But the Treasury Borrowing Advisory Committee has recommended both that the Treasury increase the proportion of T-bills in its funding mix and increase the size of future coupon auctions, starting as early as next quarter. We expect these recommendations will be heeded. Question 3: Who Will Buy All These Bonds? A full breakdown of Treasury demand from different financial market actors is beyond the scope of this report. However, there is one sector that will need to greatly increase its holdings of Treasury securities as reserves are drained. That is the banking sector. The relatively new Liquidity Coverage Ratio (LCR) mandates that banks hold high-quality liquid assets (HQLA) in an amount sufficient to cover net cash outflows during a stressed 30-day period. HQLAs consist of Level 1 assets and Level 2 assets. Level 1 assets are bank reserves and Treasury securities, Level 2 assets are other riskier securities such as Agency MBS. A haircut is applied to level 2 assets for the purposes of calculating HQLA. Based on disclosures from the eight U.S. Systemically Important Financial Institutions (SIFIs), we calculate that HQLAs total about $2.4 trillion from those 8 banks alone (Table 1). If we assume that required HQLAs increase at a pace of about 4% per year (in line with expected growth in deposits), then that represents close to $100 billion of baseline Treasury demand next year and in 2019. This demand will also have to increase to compensate for the draining of reserves from the system (Chart 9). Table 1Liquidity Coverage Ratios For The 8 U.S. SIFIs Chart 9Bank Balance Sheets Loaded With Reserves At least at present, the eight largest U.S. banks do not have much of a buffer above the 100% mandated LCR. This means they will have to be active buyers of securities in order to compensate for lost reserves and keep their ratios stable. Question 4: What Will Be The Market Impact? It has been our long-standing view that the bulk of the impact on Treasury yields from Federal Reserve asset purchases can be attributed to signaling about the future path of short rates. In fact, throughout the entire QE period, there remained a strong positive correlation between long-maturity real Treasury yields and the number of rate hikes expected during the next 24 months (Chart 10). Chart 10Real Yields Driven By Rate Expectations Even theoretically, as Michael Woodford explained in his seminal Jackson Hole address from 2012,7 there is little reason to expect that central bank asset purchases exert an impact on bond yields beyond signaling about the future path of interest rates: In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, [...]. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, [...] the market price of one unit of a given asset should not change [...]. A more thorough empirical examination also suggests that the "signaling channel" explains most of the reaction in long-maturity Treasury yields to announcements about Fed asset purchases. We looked at a sample of dates where the Fed either made or teased an announcement related to its asset purchases, and then looked at how different financial markets reacted to those announcements. Chart 11 shows changes in the 10-year Treasury yield on the days in our sample versus changes in our 24-month fed funds discounter - the expected number of rate hikes during the next 24 months as discounted in the overnight index swap (OIS) curve. The chart shows a very strong linear relationship between changes in the 10-year Treasury yield and in expected rate hikes on those days. Chart 1110-Year Treasury Yield Vs. 24-Month Fed Funds Disc Chart 12 uses the same sample of dates, but this time looks at the change in the 10-year Treasury yield versus the change in the 10-year OIS rate. The pay-off on overnight index swaps is directly tied to the level of the fed funds rate. Therefore, if Fed asset purchases exert some impact on Treasuries above and beyond sending a signal about the future path of the fed funds rate, we should expect that impact to show up in Treasury yields but not in OIS rates. However, Chart 12 shows that changes in the 10-year Treasury yield and in the 10-year OIS rate remained tightly linked throughout our sample. Chart 1210-Year Treasury Yield Vs. 10-Year OIS Rate* Following Announcements Related##br## To Federal Reserve Asset Purchases Why is it important that the impact of Fed asset purchases on Treasury yields was mostly about signaling? It is because the Fed is following a "subordination strategy" with respect to the wind-down of its balance sheet. It plans to provide us with the schedule of balance sheet run-off in advance, and then leave that schedule un-touched regardless of economic developments. Put differently, it will respond to deteriorating economic conditions by cutting the fed funds rate before it alters the pace of balance sheet run off. In essence, the link between the Fed's balance sheet and signals about the path of the fed funds rate has been severed. As long as the "subordination strategy" is strictly enforced, we should not expect much of an impact on long-maturity Treasury yields from the unwinding of the Fed's balance sheet. Question 5: Are There Any Other Potential Market Impacts? Where Fed asset purchases essentially removed Treasuries (and MBS) from the market and replaced them with bank reserves (cash), the running down of the Fed's balance sheet will reverse this swap. Supplying securities into the market and removing cash. Some have argued that this removal of cash could lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.8 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart 13). Chart 13Basis Swaps, Reserves And The Dollar One possible chain of events is that as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model9 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories are correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Bottom Line: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 2, 2017, available at usbs.bcaresearch.com 2 For further details on the monitor please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 017, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/newsevents/speeches/2017/dud170907 4 For a detailed description of the differences between a floor and corridor system please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 5 For simplicity we assume a constant pace of $1 billion MBS refinancing every month. This is somewhat below recent averages to account for the likelihood that interest rates will rise. 6 https://www.treasury.gov/press-center/press-releases/Pages/current_PolicyPressRelease.aspx 7 http://www.columbia.edu/~mw2230/JHole2012final.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ 9 http://www.bis.org/publ/work592.pdf Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Fed vs. BoE: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. USTs vs. Gilts: Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklists: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Feature Inflation: Waking Up In The U.S., Peaking Out In The U.K. The bull market in risk assets remains powerful. Investors have shrugged off the worries about U.S. hurricanes and geopolitical tensions and have returned to focusing on the global growth and inflation backdrop. The fact that the S&P 500 could close at a new all-time high just above 2500 last Friday, shortly after another North Korean missile launch and a terrorist attack on the London Underground, speaks volumes about the renewed confidence (or is it hubris?) of investors. For bond markets, two events stood out - the firming read on August U.S. CPI inflation data and the surprisingly hawkish commentary from the Bank of England (BoE). We advise that investors pay more attention to the former and fade the latter. The U.S. inflation data is far more important, as it showed a decent rise in core inflation after five months of very weak prints (Chart of the Week). Chart of the WeekUSTs At Risk From A Rebound In Inflation A rebound in inflation is critical to our call for U.S. bond yields to rise over the next 6-12 months, as it would bring Fed rate hikes back into play. Right now, there is still a significant gap between market expectations for the fed funds rate by the end of 2018 and the current FOMC projection ("dot"). If the latest inflation data is the beginning of a sustained period of faster monthly price increases, then there is room for investors to reprice their expectations for both inflation and the funds rate (bottom two panels). There is a risk that the median FOMC rate projection for next year comes down a bit when the new "dots" are released after this week's FOMC meeting. Although with market-based inflation expectations firming, and survey-based measures holding steady near the Fed's 2% target amid easing financial conditions, the FOMC may choose to hold steady and wait to see if the August inflation data is the beginning of a trend - especially with the Fed set to announce the timing and details of the reduction of its balance sheet at this week's meeting. Downgrading interest rate expectations while also starting the unwind of the balance sheet could send a confusing message to markets. At the same time, any shift to a more hawkish or less dovish message from the Fed would be taken negatively by the Treasury market. The experience of Gilts last week is a warning sign about how unprepared investors are for a change in tone from central bankers. The language in the statement released after last week's BoE Monetary Policy Committee (MPC) meeting suggested that a rate hike may come within the next few months if U.K. economic growth evolves along the lines of the MPC's forecasts. That was enough to trigger a bear-flattening move in the Gilt curve, with the markets quickly pricing in one full additional rate hike by the BoE over the next year (Chart 2, second panel). A similar move could happen if the Fed were to send any new hawkish signals, although that is unlikely to occur at this week's FOMC meeting. We see a greater potential for the Fed's forecasts to be realized than the BoE's over the next year. Financial conditions have eased and leading indicators are still pointing to a reacceleration in U.S. growth in the coming months. The impact of the hurricanes in Texas and Florida will be a drag on growth in the 3rd quarter of this year, but this will not be enough to materially impact the Fed's growth forecasts for 2018. Meanwhile, the inflationary backdrop for the U.S. may finally be bottoming out, for a few reasons: 1. Our CPI diffusion index rising back above the 50 line in August (Chart 3, top panel), although additional gains will be necessary to herald a more sustained rise in core inflation. Chart 2Markets Have Bet Heavily##BR##On Central Bank Inaction Chart 3U.S. Inflation##BR##Stabilizing? 2. The U.S. labor market continues to tighten, with the gap between the "jobs plentiful" minus "jobs hard to get" indices from the Conference Board's consumer confidence survey widening to the widest level since 2001 (2nd panel), putting upward pressure on wage growth. 3. One of the biggest sources of the surprising downturn in core inflation seen in 2017, the plunge in wireless phone prices back in the spring, has fully stabilized (3rd panel). That decline alone represented a drag on the rate of inflation for core CPI services (excluding shelter) of 1.2 percentage points (bottom panel), and on overall core CPI inflation of around 35bps - ½ of the total decline in core CPI inflation since January. As the impact of that collapse in wireless charges falls out of the inflation data in the coming months, the drag on core CPI will fade. There is now a much better chance for the Fed's inflation forecasts to be realized next year, especially once the impact of a weaker dollar (and higher energy prices) is taken into account. While some of the doves on the FOMC may downgrade their inflation forecasts this week, a major reduction is unlikely in the absence of signs of a weakening U.S. labor market or renewed strength in the U.S. dollar. The U.S. backdrop contrasts sharply with what is going on in the U.K. While the labor market is even tighter there than in the U.S., the current upturn in U.K. inflation has also occurred alongside a sharp depreciation of the Pound since the 2016 Brexit vote (Chart 4). The currency has stabilized over the course of this year, with the year-over-year change in the BoE's trade-weighted index now nearly flat (bottom panel). Against this backdrop, inflation is more likely to peak out than reaccelerate from current levels. A similar argument can be made for the U.K. economy. Leading economic indicators have rolled over, while actual real GDP growth has decelerated (Chart 5, 3rd panel). Consumer confidence has steadily declined as the currency-driven inflation increase has eroded real income growth. This has created a very odd divergence between falling confidence and an increased market expectation for BoE rate hikes over the next year, which typically move in unison (bottom panel). Add in the ongoing uncertainties over Brexit that continue to weigh on business confidence and investment spending, and it is far more likely that the U.K. economy will lag versus the BoE's forecasts. Chart 4Currency Impact On U.K. Inflation Is Fading Chart 5Why Should The BoE Hike? For now, we are maintaining our recommended neutral allocation on Gilts in our model bond portfolio. Although we would view any additional widening in yield spreads between Gilts and U.S. Treasuries and core European yields as an opportunity to move to overweight. Simply put, the odds are far greater that the Fed's economic and inflation forecasts for the next year will be realized than those of the BoE, suggesting that there is more upside risk for yields in Treasuries than Gilts. Bottom Line: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklist Update Back in February of this year, we introduced a list of indicators we need to monitor to determine if our recommended defensive duration stance on U.S. Treasuries and German Bunds was still warranted.1 These "Duration Checklists" combined data on overall global growth, as well as U.S. and Euro Area economic activity, inflation, investor risk-seeking behavior and technical positioning on government bonds. At the time, the Checklists were almost unanimous in pointing to a period of rising bond yields based on an improving growth profile and slowly rising inflation pressures. We updated the Checklists in May and, for the most part, the majority of the indicators were still flagging more upward pressures on yields, although some series on global growth and inflation had softened.2 With the benefit of hindsight, we now know that these factors - especially the pullback in U.S. inflation pressures - were enough to trigger a significant bond rally. With the U.S. inflation downdraft now in the process of stabilizing, as discussed earlier, this is now a good opportunity to revisit our Duration Checklists to assess the current backdrop for bond yields. The broad conclusion is that the majority of the indicators are still pointing to higher bond yields in the months ahead (Table 1). Table 1A Bearish Message From Our Duration Checklists Global economic activity indicators are mixed, but may be bottoming. The global leading economic indicator (LEI) continues to rise, heralding a continuation of the current economic uptrend (Chart 6). The breadth of that advance, however, is fading with our LEI diffusion index having fallen below the 50 line, meaning that there are more countries with a falling LEI. The global ZEW indicator of investor sentiment is also trending downward, another factor weighing on yields. The near-term dynamics on growth are starting to shift more bearishly for bonds, however, with the global data surprise index rising and the latest read on our Global Credit Impulse indicator ticking upward. We are giving a "check" to 3 of the 5 global growth elements in our Duration Checklists (LEI, data surprises, Credit Impulse), which represents a bond-bearish shift from the last update of the Checklists in May when only the LEI warranted a "check". Domestic economic growth in the U.S. and Euro Area is solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe are rising, as is consumer and business confidence (Charts 7 & 8). The latter is not surprising given the strong growth in corporate profits on both sides of the Atlantic that our models expect will continue. This bodes well for future growth momentum, as firms will not be forced to retrench on hiring and investment spending to protect profitability. We are giving a "check" to all domestic growth components of our Duration Checklists, highlighting that the economic backdrop remains bond bearish. Chart 6Yields Are Exposed To##BR##Improving Global Growth Chart 7A Solid U.S.##BR##Economic Expansion Chart 8European Growth Momentum##BR##Is Bearish For Bunds Realized inflation has dipped, but the worst looks to be over. In our Checklists, we include measures on energy prices, labor market tightness and wage inflation as the primary inflation indicators to monitor. On that front, the story still looks fairly benign for U.S. inflation given the dip in wage inflation measures like Average Hourly Earnings growth and the Atlanta Fed Wage Tracker (Chart 9). The unemployment gap (unemployment rate vs. NAIRU) is still negative, and other wage measures like the wage & salaries component Employment Cost Index are steadily expanding, suggesting that the underlying wage dynamics in the U.S. may not be as slow as indicated by Average Hourly Earnings. In the Euro Area, wage growth has accelerated above 2%, occurring alongside a grinding increase in core inflation and an unemployment gap that is almost fully closed (Chart 10). Meanwhile, the downward momentum in the growth of energy prices - denominated in both dollars and euros - has bottomed out after the sharp decline since the beginning of the year, although the rebound has been tepid so far (top panel of Charts 9 & 10). Chart 9Not Much Inflationary##BR##Pressures On UST Yields Chart 10Core Inflation & Wages Are##BR##Grinding Higher In Europe The most significant divergences between the regions exist within the inflation elements of our Checklists. For wage growth, we are giving an "x" to the U.S. but a "check" to Europe. For the unemployment gap, we are giving a "check" to both regions. For energy prices, however, we are not giving any indication (a "?") until we see more decisive evidence of a sustained acceleration that is pressuring headline inflation rates even higher. Both the Fed and ECB are biased to remove monetary accommodation. The Fed is in the midst of a rate-hiking cycle that began in late 2015, and is now about to begin the long process of shrinking its swollen balance sheet. The ECB has been slowly preparing the market for a shift to a slower pace of asset purchases, although rate hikes are still at least a couple of years away. For both central banks, we are giving a "check" for having a more hawkish/less dovish policy bias that is not bullish for bonds. Investors remain in risk-seeking mode. The way that we interpret investor risk aversion in the Checklists is if growth-sensitive risk assets like equities and corporate credit are rallying, then this is bearish for government bonds. The logic here is that private investor demand for Treasuries and Bunds is diminished when risk assets are rallying, as long as equities are not stretched to a point where the risks of a correction are elevated (i.e. indices trading 10% above their 200-day moving average). Also, the easing of financial conditions stemming from rallying stock and credit markets is a boost to growth that central banks will likely respond to by becoming less accommodative. From that perspective, the persistent bull markets in equities and corporate credit on both sides of the Atlantic are bearish for Treasuries (Chart 11) and Bunds (Chart 12). With stocks not looking stretched versus the medium-term trend and with volatility remaining low, all the related elements of our Checklists earn a "check". Chart 11Still A Pro-Risk Bias##BR##Among U.S. Investors Chart 12Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond yields do not look stretched to the upside from a technical perspective. The Treasury sell-off from the 2017 peak back in March has pushed the 10-year yield back below its 200-day moving average, while also boosting the 6-month total return into positive territory (Chart 13). There is also a persistent net long position in 10-year Treasury futures (bottom panel). Add it all up and the technical backdrop for Treasuries is stretched in a way pointing to greater near-term risks of higher yields. In Europe, momentum measures all look neutral (Chart 14) and are no impediment to rising yields. We give all technical elements of our Duration Checklists a "check". Chart 13UST Rally Since March##BR##Is Looking Stretched Chart 14Neutral Technical##BR##Backdrop For Bunds Net-net, the Checklists show that the majority of indicators are still pointing to a bond-bearish backdrop. The only bond-bullish factors are the soft inflation readings in the U.S. although that may be in the process of shifting, as discussed earlier. There is not a major difference in the number of checkmarks for both the U.S. and Euro Area Checklists, thus we see no reason to favor either market from a relative perspective - there is pressure for both Treasury and Bund yields to rise. Thus, we are maintaining our recommended below-benchmark medium-term duration stance in both the U.S. and core Europe within hedged global bond portfolios. Chart 15UST Yields Have More Near-Term Upside From a shorter-term tactical perspective, however, we see more upside for Treasury yields vs Bunds with U.S. economic data surprising to the upside at a faster pace than in Europe (Chart 15). Throw in the potential for U.S. inflation to also rise above depressed expectations and a wider Treasury-Bund spread - a trade that we currently have in our Tactical Overlay portfolio and which goes against the tightening currently priced into the forwards - is the more likely outcome in the next few months. Bottom Line: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Fade The "Trump Fade"", dated May 23rd 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Finally, an upside surprise on inflation. Recent significant developments reinforce BCA's bullish view on crude oil. Investors should consider the Monthly Report on personal income and spending, and not the quarterly GDP data, to gauge hurricanes' impact on economy. While the Fed will consider impact of Harvey and Irma, policy will ultimately be made on health of underlying economy. Feature Chart 1Rally For Risk Assets##BR##A Week Before The FOMC Risk assets and oil prices rose last week along with Treasury yields ahead of this week's FOMC meeting. Both the S&P 500 and the Dow hit new highs last week as the dollar moved lower. The stock-to-bond ratio also climbed, approaching the highs it reached earlier this year (Chart 1). All of this occurred amid an absence of any meaningful news on corporate earnings, aside from Apple's launch of the latest iPhone. Q3 earnings season is still a month away. Our base case projects stocks outperforming cash and bonds over the next 6-12 months, but in early September we recommended that clients be prudent, pare back any overweight positions and hold some safe-haven assets within diversified portfolios. The most significant movement in assets prices last week came in the U.S. Treasury market. Aided by hints of some progress on tax cuts in Washington less damage than initially feared from Hurricane Irma's impact on Florida, and despite another rocket launch by North Korea, the 10-year Treasury yield moved from near 2.0% in the first week of September to 2.20% on September 15. BCA's U.S. Bond Strategy service notes1 that bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Finally A Surprise On Inflation Chart 2Does One Month Make A Trend? After five months of downside surprises, U.S. core CPI met expectations in August. It is still too soon say that this is enough for the Fed to raise rates again this year. To get a better sense of the underlying trends, we like to break core CPI into three sub-groups: shelter, core goods and core services ex-shelter and medical care. Shelter, which accounts for over 40% of core CPI, rose 0.4% m/m in August. This was the biggest contributor to core CPI during the month. Our shelter model suggests that this strength is unlikely to persist. On the flip-side, core goods prices (25% of core CPI) fell 0.1% m/m. Given the weakness in the dollar, core goods prices should soon begin to rise. To some degree, a slowdown in shelter and a pick-up in core goods could offset each other over the coming months (Chart 2). Therefore, a sustained pick-up in overall core inflation requires an upturn in core services ex-shelter and medical. This sub-component of core CPI is the most tightly correlated with wage inflation. There was a slight tick higher in annual core services ex-shelter and medical inflation in August. However, it is still near a 25-year low of just 1.1%. Bottom Line: Following five months of persistent downside surprises, the 0.2% m/m increase in core CPI during August was a welcomed change for the Fed. However, one month does not make a trend and Fed will need to see more evidence of inflation turning the corner before raising interest rates again. Any rise in oil prices would also give inflation a lift, although it would affect the headline more than the core inflation rate. Bullish Oil Supply And Demand Recent significant developments reinforce BCA's bullish view on crude oil. The International Energy Agency (IEA) revised its forecasts for global oil demand. Oil consumption will be 100,000 bpd higher this year than the IEA's previous projection. Furthermore, renewed turmoil in Libya curbed production by 300,000 bpd from a 4-year high of more than 1 million bpd. BCA's Commodity & Energy Strategy service states that while predicting OPEC compliance is tricky, little to no cheating will occur. At worst, Saudi Arabia will step in and curtail production if Libya and/or Iraq begins to pump oil above quota. Finally, the Energy Information Administration (EIA) in the U.S. lowered its estimated shale oil output by 200,000 bpd for this year's third quarter. The decreased estimation confirms BCA's assertion that the EIA has overestimated the pace of the shale production response during 2017. Chart 3Drawdown In Global Oil##BR##Inventories Is Underway Taken together, these factors will help to improve the global net demand/supply balance by 600,000 bpd, if the current situation remains unchanged. As a result, global oil inventories will continue to be drawn down (Chart 3). Severe weather in the U.S. has temporarily distorted the energy markets. Crack spreads have widened in the U.S. as product inventories have declined along with Brent - WTI spreads. Nonetheless, BCA's commodity strategists remain bullish on crude oil, forecasting a rise in WTI to over $55/bbl and Brent to $60/bbl by year-end. Looking to next year, crude prices could go higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. A sudden jump in the U.S. dollar could risk BCA's bullish view. Bottom Line: There is a disagreement between the market's view of the fundamentals of the global oil balance, which is guided by the EIA data, and BCA's view that is driven by the OPEC 2.0 framework.2 Oil prices could spike higher if the market adheres to the OPEC framework. BCA's Equity Trading Strategy service recommends an overweight to the S&P 500 Energy Sector and initiated an overweight in the Oil and Gas Refining and Marketing sub-group on September 11, 2017.3 Hurricane Redux Turning to the U.S. hurricane destruction, history shows that natural disasters have only a passing effect on the U.S. economy, the financial markets and the Fed.4 Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the storms on Houston, Florida and nearby southern states. The U.S. data gathering agencies (BEA, BLS and Census) have processes to ensure that the storm's sway is reflected in the economic data. In the past, all three have produced post-disaster evaluations and will likely release the same type of information in the months ahead. Most of the storms' effects will be felt in the September data, but have already affected the initial claims data for the last week in August and the first week of September. The storms will also buffet the Q3 GDP (due out in late October). However, GDP data may not provide a comprehensive picture; GDP is not directly affected by natural disaster losses involving property, plants, equipment and structures. However, GDP can take a direct hit from the loss of productive capacity linked to a storm. The BEA notes that "while GDP may be affected by the actions that consumers, businesses, and governments take in response to a disaster, these responses are generally not separately identifiable, and they may be spread out over a long period of time." Investors should consider the monthly report on personal income and spending, and even more, the regional accounts by state, and not the quarterly GDP data, for details on the storms' economic fallout. Only hurricanes Katrina and Rita warranted a mention in the Q3 2005 GDP release, and none of the other major storms since that time have been noted by the agency. On the other hand, the personal income and spending reports released after all the major hurricanes since 2005 have provided key specifics on incomes. For example, the BEA stated that "work interruptions" linked to Hurricane Sandy reduced wages by $18 billion in October 2012 when the storm hit the northeastern U.S. The Bureau of Economic Analysis (BEA) also tends to note a storm's influence on other primary income categories including personal rental incomes, proprietors' incomes, and other current transfer receipts (i.e. insurance payments received). Table 1Total Federal Spending And Total Economic Damage For Selected Hurricanes, 2000 To 2015 A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP growth (Table 1). CBO notes that most of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart 4). Chart 4Federal Government Outlays For Hurricane Relief The severe weather in the U.S. has raised the odds that the Trump administration and Congress will make progress on fiscal policy this fall. We think that the outlines of a tax bill will emerge in the next month or so, and while the probability of passing legislation this year is still low, BCA's Geopolitical Strategy service expects the market to react when it sees the bill. The implication for investors is that the President Trump trades (Chart 5) that have unwound since the start of the year may soon become profitable again. The recent agreement between Trump and the Democrats to extend the debt ceiling and avoid a government shutdown support our stance. Chart 5Trump Trades Making A Comeback? Bottom Line: The hurricanes may have a bearing on the economic data for the next few months. Investors should closely monitor the input data to GDP, but not GDP itself. However, we do not anticipate that any economic disruptions from the storms will have a meaningful influence on near-term Fed monetary policy. Disasters And The Fed The hurricanes will probably play a supporting role in the Fed's outlook on the economy, inflation and labor market at this week's meeting. The FOMC statement will mention the storms and Fed Chair Yellen may include them in her opening remarks. Moreover, the news conference will provide another opportunity to discuss the issue. For example, the FOMC statement released in mid-December 2012, six weeks after Sandy, stated that "economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions". Fed staff noted that manufacturing production was held down by Sandy and that household spending, notably vehicle sales, declined in October due to the storm (Table 2). Similarly, the wrath of Hurricanes Katrina and Rita was noted in FOMC statements and minutes in the fall and early winter of 2005. For example, in the statement released at the meeting after Katrina hit in August 2005, the FOMC observed: "The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term." Fed policymakers made similar observations in the aftermath of other natural and man-made disasters in the past 25 years (Table 2). Table 2FOMC Reaction To Disasters, Natural And Man Made Bottom Line: Fed officials will consider the disruptions to the economy and economic data caused by Hurricanes Harvey and Irma, but ultimately make policy decisions based on the underlying strength of the economy, labor market and inflation. FOMC Preview The FOMC will initiate shrinking its balance sheet at this week's meeting, but neither BCA nor the market anticipate that the Fed will bump up rates. Moreover, the Fed will need more evidence that inflation, inflation expectations and/or inflation surprise has turned higher before resuming its rate hike regime. Furthermore, there is still a significant disconnect between the market and the Fed concerning rates for the next 12 months, and how that gap closes could be crucial for the financial markets, especially the bond market. At 43 basis points, the gap between the June dot plots and the market on the Fed funds rate in the next 12 months remains near its widest level of the year. The market is currently predicting only 30 bps in increases in the next 12 months. However, an uptick in inflation could quickly change that view (Chart 6). Despite the disagreement on rates, the Fed and the market are mostly aligned on the economy, the labor market and inflation, at least in 2017. For the first time, the FOMC will provide projections for 2020 at this week's meeting. At 4.4% in August, the unemployment rate is a mere tenth above the Fed's end-2017 forecast, but it is 0.2% below the central bank's latest estimate of full employment (4.6%). The Fed's measure of full employment has declined in recent years and we would not be shocked to see a drop again this week. The consensus outlook for the unemployment rate matches the Fed's path through the end of 2018 (Chart 7 and Chart 8). Chart 6Big Disagreement Between The Fed ##br##And The Market On Rates Chart 7The Fed Vs. The Market Chart 8The FOMC's "Long Run"##BR##Forecasts Since 2012 The economy is on pace this year to grow at the Fed's 2.2% projection but is running above the FOMCs long-run calculation of 1.8%, which is the low point since the Fed started publishing these long-run projections in 2009. The consensus forecast for GDP in 2018 and 2019 is slightly above the upper end of the Fed's range set in June (Chart 7 and Chart 8). The Fed and the market are relatively close on inflation this year, but there is still a wide gap in 2018 and beyond. In June, the Fed lowered its inflation forecast for 2017 to 1.6% from 1.9% in March. PCE inflation is at only 1.4% (year-to-date in 2017), so there is not much disagreement in this regard. The market does not agree with the Fed's view that inflation will return to 2.0%, and this is a key reason why the 10-year Treasury yield recently touched a new post-election low at 2.0%, although geopolitical tensions also played a role. The central bank's view of inflation in the long run has not deviated from 2.0% since 2012. Bloomberg consensus estimates for core inflation for this year and next are below the low end of the Fed's forecast range (Chart 7 and Chart 8). Market participants and some Fed officials are still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with an unemployment rate that is below the Fed's estimate of full employment. (Please see a BCA Special Report, "Did Amazon Kill The Phillips Curve?").5 Who Will Be The Next Fed Chair? As some investors consider the Fed's next policy move, others are taking a longer view and thinking about Fed Chair Yellen's replacement. Yellen's term as Chair will end in February 2018, and the markets have not yet shown any concerns about her potential replacement. Until last month, the frontrunner to replace Yellen was Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others.6 Several new names have emerged as possible Fed nominees as Cohn fell out of favor in the White House in early September. Kevin Warsh, Glen Hubbard and John Taylor, are all high-profile economists with links to the GOP, but Warsh stands out because he served on Trump's Strategic and Policy forum before it disbanded in August, and was a Fed Governor in the early 2000s (Table 3). Hubbard, who is currently an academic, was President George W. Bush's chief economist. However, he has not worked with Trump and has no Fed experience. John Taylor is well known in monetary policy circles, but has no Fed or government background, nor has he served with Trump. Taylor advocates for rules-based monetary policy.7 Another possible name, Larry Lindsey, an advisor to George W. Bush's campaign in 2000, a Fed Governor in the 1990s, and worked in the Reagan White House but he has no connection to Trump. He has recently spoken in favor of the House tax plan. Table 3Characteristics Of Fed Chairs Since 1970 The other two names under consideration - Richard Davis and John Allison - may have difficulty winning confirmations by the Senate. Both men were CEOs at major banks although neither have directly served Trump, nor been at the Fed or in government. Allison, a former president of the Libertarian Cato Institute, has argued that the Fed should be abolished and blamed the Fed for the financial crisis. The timing of Trump's announcement on Yellen's replacement may be critical. As a reminder, names floated by the Obama White House in the summer of 2013 were mainly rejected by the markets. Yellen's official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. As we noted in the sections above, there is already a wide discrepancy between the Fed and the market over the pace and timing of rate hikes in the coming year. BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) currently places fair value at 2.67%.8 Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68%. Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Bottom Line: Markets will be increasingly concerned in the next six weeks about the next Fed Chair and his or her policies. While the reappointment of Fed Chair Yellen for another term would please the markets, several other possible successors would not. We anticipate that the President will make a choice within the next month. Taking a longer view, the next Fed chair will oversee the policy response to the next recession and its aftermath. Investors should understand how the next Chair views the Fed's role in the business cycle. Economy Focus: Some Good News From The Quarterly Services Survey Even with the increasingly dominant role of the service sector's contribution to the economy (~69% of GDP), most of the high-frequency data are related to the manufacturing sector (~12% of GDP) (Chart 9, top panel). However, the Quarterly Services Survey (QSS), initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the services sector of the economy, including companies of all sizes (small- and medium-sized). It produces the most timely revenue data, on a quarterly basis, within the flourishing service sector. The dataset is used primarily by the BEA to estimate a more accurate picture of the national accounts, notably personal consumption and the intellectual property segment of private fixed investment. The survey is also essential for FOMC policymakers as it is very useful to track current economic performance. Even more, during the financial crisis, the BEA "aggressively responded to policymakers' needs for data on financial services". The QSS is a significant source of revisions to real GDP, as about 42% of the quarterly estimates of PCE for services is now based on QSS data. The "key services statistics" include information services; health care services; professional, scientific, and technical services; administrative and support and waste management and remediation services (Chart 9). For the first half of 2017, upward revisions to second and third estimates to real GDP stemmed from revisions to PCE services and nonresidential fixed investment, namely: health care services, financial & insurance services and intellectual property products (specifically software) and other services accounted for by cellular telephone services. The most recent QSS for 2017Q2 showed U.S. selected services total revenue rising by 3.2% over the last quarter and 6.2% over the last four quarters (in nominal terms and non-seasonally adjusted data only available). The strongest growth came from revenues of Other Services (9.4% QoQ% and 18.4% YoY) followed by Arts, Entertainment & Recreation and Administration, Support & Waste Management. Sales in Finance & Insurance and Health Care & Social Assistance, which make up about 50% of total service revenues, are advancing at a sturdy pace, as is revenue in Information services (Chart 9). Chart 9Growth For Service Sector##BR##Industries Is Broad-Based Chart 10QSS Survey Heralds Some##BR##Upward Revision To Real GDP Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see some upward revision to real consumer spending for services for the third estimate of real GDP next week (Chart 10). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report "Open Mouth Operations", published September 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance", published September 14, 2017. Available at ces.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report "Still Goldilocks", published September 11, 2017. Available at uses.bcaresearch.com. 4 Please see BCA U.S. Investment Strategy Weekly Report "Shelter From The Storm", published September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report "Did Amazon Kill The Phillips Curve?", published August 31, 2017. Available at bca.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", published July 17, 2017. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report "Trump And The Fed", published March 6, 2017. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report "The Cyclical Sweet Spot Rolls On", published September 5, 2017. Available at usbs.bcaresearch.com.
Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Overweight A neglected aspect of the catastrophe of Hurricane Harvey was the shutdown of nearly 40% of ethylene production, the key ingredient in plastics packaging for foodstuffs, still the largest customer for the containers & packaging index. While production is gradually coming back on line, near-term capacity constraints have driven a 50% spike in ethylene prices (not shown). In the end, we expect Harvey to be a transitory margin blip that is outweighed by the current global economic resurgence driving increasing global exports, particularly U.S. food exports (second & third panels). Moreover, chemical producers have committed capital for approximately 15% more capacity of ethylene production coming on stream in the next two years, meaning this price spike should prove fleeting. We think investors should stay focused on the rebound in containers & packaging pricing power and the industry's disciplined productivity focus (bottom panel). Taken together these factors should generate profit growth that will significantly outlast a hurricane-related dip. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.
Overweight As the concern over hurricanes Harvey & Irma related catastrophes transitions to repair & rebuilding, it is worth examining the home improvement retail (HIR) space. HIR stocks have barely budged since the hurricanes as the market tries to figure out the earnings impact. Reconstruction is displacing renovation demand which will drive near term sales higher; the price of lumber is the usual leading indicator for sales growth in HIR and it is reaching five year highs (second panel). However, said higher prices will mean that some of the deferred renovation demand will be destroyed, implying the hurricanes simply pulled some sales forward rather than create new demand. Still, the HIR space was firing on all cylinders before the hurricanes with roaring sales and efficiency (third panel) driving margins higher. This is not reflected in valuation multiples which are surprisingly touching ten-year lows. Surging mortgage applications (top panel) should keep renovation demand on a solid footing, despite a likely near-term hiccup; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.
Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. 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-20 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 U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016