Developed Countries
Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation
Highlights The ECB defines a euro overshoot as EUR/USD in the high 1.20s. Until then, remain cyclically long both EUR/USD and the associated SEK/USD. EUR/USD is a function of expected terminal interest rates in the euro area and U.S. Whether the Fed hikes in December or whether the ECB hikes next year is largely irrelevant. Global investors should be long the euro, but underweight the Euro Stoxx 50. European equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50.1 And prefer the FTSE100 over the Euro Stoxx 50. Feature Arguably the biggest macro trade of 2017 has been to own the euro. Year to date, the big winner is EUR/USD, which is up 15%, but even EUR/GBP is up an impressive 9%. An additional merit is that the euro has behaved like a haven currency. When risk assets have sold off sharply, EUR/USD has tended to strengthen.2 The Euro Is Stronger, But It Is Not Strong Although the euro is stronger, the ECB's own indicators for euro area competitiveness3 suggest that the euro is not yet strong. The euro needs to appreciate by at least another 5%4 to cancel the euro area's over-competitiveness versus its top 19 trading partners (Chart of the Week). Translated to EUR/USD this implies a fair value in the 1.25-1.30 range. Chart of the WeekThe Euro Is Stronger, But It Is Not Yet Strong To be clear, the ECB's competitiveness analysis assumes that the euro started its life in 1999 close to fair value. This assumption seems reasonable. In 1999, the euro area's constituent economies were broadly in internal balance with each other and had much in common. Hard as it is to believe today, in 1999 Germany and Italy scored identically on total debt as a share of GDP (Chart I-2) as well as on exports as a share of GDP (Chart I-3). Chart I-2At The Euro"s Birth, Germany And##br## Italy Had The Same Debt To GDP... Chart I-3...And Exports##br## To GDP Perhaps more significantly, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. But after its birth, the euro became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again - as a direct result of the ECB's extreme monetary easing. Seen in this bigger picture, the euro's recent rally is just a recovery from this most recent undervaluation, an argument that the ECB itself made at its last monetary policy meeting: "Regarding exchange rates, the appreciation of the euro to date could be seen as reflecting changes in relative fundamentals in the euro area vis-à-vis the rest of the world." At the same time: "Concerns were expressed about the risk of the exchange rate overshooting in the future." What would constitute such an overshooting? Based on the ECB's own analysis, we can deduce that it would occur if EUR/USD broke into the high 1.20s (Chart I-4). This is the level at which we would consider removing our cyclical overweight. Until then, remain cyclically long both EUR/USD and the associated SEK/USD. Chart I-4The Euro Needs To Rally Another 5% To Cancel The Euro Area"s Over-Competitiveness Explaining The Stronger Euro The explanation for the euro's impressive rally starts with central banks' strong commitment to 'data-dependency'. Over short periods, economic data can be noisy or "transient" giving central banks an excuse to look through the data. But over periods of 6 months and longer, the noise cancels out. So unless central banks break their commitment to data-dependency - which would mark a big shift in transparency and communication - the markets know that central bank policy must ultimately follow the hard data on GDP growth, inflation, and job creation. This necessarily means that the evolution of relative interest rate expectations and bond yields must also ultimately follow relative economic performance. Which they have done perfectly (Chart I-5). The next part of the explanation is the so-called fixed income portfolio channel (Chart I-6). The key point is that international fixed income investors make their allocations based on both bond valuations and currency valuations. Chart I-5Bond Yield Spreads Follow Relative##br## Economic Performance Chart I-6Fixed Income Flows Are The Most Volatile##br## Part Of Currency Demand When the expected interest rate in the euro area rises relative to that in the U.S., the euro bond becomes de facto relatively cheaper. As an example, let's say 1% cheaper. In this case, the international fixed income investor will shift into the euro bond until the flow makes EUR/USD symmetrically 1% more expensive. At this point, the fixed income portfolio flow will stop, and an equilibrium will reestablish at the new higher level for EUR/USD. This is because the international investor now has 1% more upside from the cheaper bond, but 1% less upside from the more expensive currency - and the two cancel out. Finally, at major turning points in monetary policy such as now, the expected interest rate that matters is the so-called terminal rate. At such major turning points, the issue for the largest fixed income portfolio flows is not the exact timing of rate hikes. Whether the Fed hikes in December or whether the ECB hikes next year is largely irrelevant. The big issue is: at what level of rates will the respective tightening cycles ultimately end many years from now? Chart I-7 and Chart I-8 illustrate that EUR/USD has recently been tracking the expected policy rate differential not in 2018 or 2019, but in 2022! Chart I-7EUR/USD Is Not Tracking Policy ##br##Rate Differentials In 2019... Chart I-8...But Rather Policy Rate ##br##Differntials In 2022 Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in other major economies. In which case, relative expectations for the terminal policy interest rate will continue to converge, long-dated bond yield spreads will continue to compress, and the euro has further cyclical upside. Losers And Winners From The Stronger Euro A stronger euro creates both losers and winners. A stronger euro hurts the competitiveness of firms selling euro priced products in international markets. Therefore, firms exporting discretionary goods and services which are price elastic could suffer a drop in sales. Against this, a stronger euro makes everyone in the euro area richer in terms of the goods and services they can buy from outside the euro area. This is particularly significant for non-discretionary items - food and energy - of which Europe is a large importer. Given that the volumes of these purchases tend to be inelastic, their price decline in euro terms significantly boosts the real spending power of euro area consumers. Chart I-9The Stronger Euro Weighs##br## On The Eurostoxx 50 (As an aside, the exact opposite applies in the U.K. The post Brexit vote slump in the pound - and the associated rise in prices - has depressed U.K. consumers' real spending power. And likely explains why the U.K. economy is now slowing.) A stronger euro also reflects a steeper yield curve, and its associated boost to bank profit margins, solvency, and credit creation. The important point is that the stronger euro's aggregate impact on an economy depends on how the losers and winners net out. For example, many people will worry that the stronger euro has made Italy 5% under-competitive versus its major trading partners. However, the drag on Italy's price-sensitive exporters could be less significant than the boost to real consumer spending and bank credit creation - netting out as a positive for Italy. Equity investors should note that most exporters in the Euro Stoxx 50 tend to be multinationals whose sales and costs are currency diversified and/or hedged. So a stronger euro should not hurt operationally. But it does hurt in the translation of multi-currency profits back into euros - the base currency of the Euro Stoxx 50. This drags down (local currency) index performance. Hence, global investors should be cyclically long the euro, but underweight the Euro Stoxx 50. European equity investors should prefer the broader based 300-constituent Euro Stoxx5 over the 50-constituent Euro Stoxx 50 (Chart I-9); and prefer the FTSE100 over the Euro Stoxx 50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Not to be confused with the Stoxx Europe 600 2 Global equities assets have suffered 11 sharply down days this year - defined as the MSCI World index (in local currency terms) down more than -0.5%. And on 9 of those 11 days, EUR/USD has rallied 3 Available at https://www.ecb.europa.eu/stats 4 The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs, GDP deflators, and consumer price indices. Updated to August 29 2017, the three indicators suggest that the trade-weighted euro is still undervalued by 5%, 11% and 6% respectively. 5 Not to be confused with the Stoxx Europe 600 Fractal Trading Model* This week we are initiating a short nickel / long silver commodity pair trade with a profit target / stop loss at 8%. In other trades, short MSCI Turkey / long Eurostoxx600 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Neutral At the beginning of the summer, we downgraded the S&P health care equipment (HCE) index to neutral for three main reasons: valuations had shot higher, demand had downshifted and pricing had cooled substantially. Relative valuations have since fallen back (top panel), but the operating environment has worsened, providing confirmation that our downgrade was well-timed. Both HCE orders and production crested in the middle of 2016 and have been falling since, production precipitously so (second panel). At the same time, medical equipment relative selling prices have been contracting (third panel), indicating the industry could be in oversupply despite slowing production. The likely result is contracting margins and valuation multiples. Still, the news is not all bad. New health care facility construction has recovered recently and investment in medical equipment may follow suit (bottom panel), potentially portending a resurgence in demand. On balance, we think it prudent to sit on the sidelines and wait for evidence of a recovery in pricing power before reentering the fray; stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: ABT, BAX, BCR, BDX, BSX, DHR, EW, HOLX, IDXX, ISRG, MDT, RMD, SYK, VAR, ZBH.
Highlights Hurricane Harvey will prove a bigger market-mover than North Korea's latest missile test; The worst flood in Houston's history will improve U.S. policymaking and remove domestic risks; North Korea justifies hedging against violent incidents, but actors are constrained from full-scale war; Insights from our travels in Asia suggest that U.S.-China cooperation is still meaningful. China's reform reboot faces constraints; Abenomics is not done yet. Feature As we go to press, two crises are developing. The one that has rattled the markets - and that we focus on in this Weekly Report - is the North Korean missile launch. However, we think the more investment-relevant one is the slow-moving Hurricane Harvey, which is about to inundate Houston - a metropolitan area with nearly 7 million people - with more rain. We cannot predict the ultimate impact on the economy of the developing natural disaster, but we do know that Houston is experiencing the greatest flood in its history. The scale of human suffering is likely being massively underestimated at present. Comparisons with Hurricane Katrina are not without merit, but Houston has a population about five times that of New Orleans. Investors may rightly ask, so what? The stock market actually rallied at the height of Hurricane Katrina and one would struggle to pick its date on a chart of the S&P 500. The impact on the economy and markets is likely to be tepid in the near term once again. The significance of Hurricane Harvey is its likely impact on politics. First, there is now no chance that the debt ceiling will be breached. We discussed the low odds last week and we reiterate them here. Second, odds are that a government shutdown is unlikely as well. It is unfathomable to shut down the government during an emergency. Imagine if the Federal Emergency Management Agency (FEMA) had to cease operations. Wall or no wall on the Mexican border, Republicans in Congress and the White House will fund the government. More than that, Americans suffering in a Red State that voted for President Trump could be the catalyst that Republicans need to put their intra-party differences aside and start working with vigor on legislation, including tax reform. We could even contemplate legislative action on a bipartisan infrastructure plan, although the ability of U.S. policymakers to put aside grief and focus back on partisan bickering never ceases to amaze. The bottom line for us is that in six months' time, when investors look back on late August 2017, it will be Hurricane Harvey that is cited as having been market-relevant in the long term, not North Korea's n-th missile launch. That said, North Korea remains relevant. It has launched an avowed ballistic missile over Japan for the first time (as opposed to a space launch vehicle, which it has done in 1998 and 2009). The launch originated near Pyongyang, a warning to the U.S. that any strikes against launch sites would be complex (involving civilians) and tantamount to an attack on the capital and a declaration of war. The United States and its allies will be forced to respond to this brinkmanship by trying harder to establish that the military option is indeed credible despite the well-known constraints (the decimation of Seoul). Therefore more market volatility will ensue in the coming months and year. We do not rule out major violent incidents, though full-scale war still seems highly unlikely due to hard constraints on the various actors. (Please see "Appendix" for our updated checklist on whether the U.S. will attack.) While we do not expect either Pyongyang or Hurricane Harvey to derail the bull market, we recognize that valuations are stretched, volatility is low, and the market may be looking for a reason to sell off significantly. In this report, we discuss insights on North Korea and other key issues gleaned from our recent travels abroad. BCA's Geopolitical Strategy went on the road this summer for five weeks. We visited the American Midwest, Australia, New Zealand, Singapore, Taiwan, China, Japan, South Korea and the U.K. There we had the pleasure of speaking with clients across the asset management industry. Each region had its own set of specific questions and concerns, as well as insights. Over the next two weeks, we plan to share these with our entire client base. Going on the road is critical for investment strategists. It is an opportunity to stress-test and sharpen one's view through interaction with sophisticated investors. Meeting clients also ensures that you are asking the right questions. We are happy to report that our three main questions - how stimulative will U.S. tax reform be; is China willing to deleverage; and is Italy a potential source of global risk-off - are indeed on all of our clients' minds. This does not mean that everyone came to the same conclusions that we did, but at least we know that we are looking for the same answers. Sino-American Split Is Overstated Investors are no longer as quick to dismiss one of our central geopolitical theses: that the U.S. and China are on a path likely to end in the "Thucydides Trap."1 However, one of our clients was not so sure that U.S.-China relations are deteriorating as rapidly as they appear to be. He observed a pattern in bilateral trade that suggested to him that the two countries are working together, under the table, to keep relations from collapsing despite the unprecedented challenges posed by the post-2008 global political and economic environment. He began with the simple point that the U.S.'s rising trade protectionism against Chinese steel in recent years actually made it easier for President Xi to take aim at overcapacity problems in the steel sector in China. After U.S. steel imports from China collapsed, from 20% of total in 2008 to 3% in 2016, China was able to embark on a long-delayed purge of excess steel capacity, shutting down a reported 87mmt over the past year and a half (Chart 1). China moved up the steel product value chain partly as a result of U.S. actions.2 China also appears to have responded promptly to U.S. complaints about agricultural imports. In late 2016, amid a heated and protectionist presidential campaign, the U.S. government threatened to impose tariffs on China's grain exports and demanded that subsidies be removed so that U.S. companies could compete on a level playing field in China's domestic market. Corn prices were at a nine-year low; Beijing was giving rebates to domestic corn exporters and had amassed large corn inventories. Within a few months, in March 2017, China launched the agricultural side of its supply-side reforms. It removed the supports for corn, allowing prices to plummet and making way for lower Chinese supply and thus more U.S. imports (Chart 2). Chart 1U.S. And China Attack Chinese Steel Capacity Chart 2China's Supply-Side Agriculture Reforms Most recently, the client emphasized, China launched one of its periodic crackdowns on intellectual property violations.3 Enforcement was observable in China's mainstream online services, which largely lost the ability to stream content for which they lacked the rights.4 As with steel, China has a self-interest in these reforms, especially as it generates its own intellectual property. But it cannot have detracted from China's urgency that the U.S. announced a formal investigation in early August to determine whether China's intellectual property violations deserve punitive actions.5 It is as if China anticipated the U.S.'s moves coming out of the U.S.-China Comprehensive Economic Dialogue in July. In these and many other cases, a pattern seems to emerge: U.S. trade grievances boil up, U.S. authorities threaten punitive actions, China responds to the threat by vowing retaliation and pushing through supply-side reforms that are already in its interest. The process appears to be a win-win, however precarious. The client also suggested that the U.S. may be offering to become more constructive toward certain Chinese initiatives. For instance, China is pressing forward on the long-delayed launch of an oil futures contract on the Shanghai International Energy Exchange in the second half of 2017. This new benchmark would ostensibly rival Brent and West Texas Intermediate contracts and be settled in RMB instead of USD. To our client, China's moving forward with this scheme, immediately after top-level trade negotiations with the U.S., seemed to reveal the U.S.'s tacit support for RMB internationalization. Certainly the U.S. nodded at the IMF including the RMB in its special drawing rights basket.6 Presumably, then, the U.S. and China have not entirely lost the ability to deal with each other on sensitive issues in an atmosphere fraught with distrust. Moreover, both sides can attempt to roll with the punches. China can blame the difficulties of necessary internal reforms on U.S. protectionism, while U.S. protectionist impulses can be mitigated via China's internal reforms. This dynamic could become the silver lining in Sino-American relations in 2018, a year in which Xi will have the best opportunity to push reforms while Trump may be most eager to take protectionist actions ahead of the midterm election. A silver lining to a black cloud, of course. Bottom Line: Risks to Sino-American relations remain serious, but the two sides still retain some ability to manage tensions. The question is how much ability? Our own view has been that 2017 would largely be a year of Trump issuing "a shot across the bow" and then negotiating. Concrete, aggressive action would be more likely to occur in 2018. This remains our baseline case. But silent coordination of the kind described above could perhaps improve trade relations enough to satisfy Trump in 2018 and delay a Sino-U.S. confrontation. China has long dealt with protectionist threats from the U.S. by conceding various reforms and policy adjustments, especially by increasing U.S. imports. The U.S. has long accepted such a response. We doubt that this tactic will be enough in this day and age, but maybe so. North Korea Could Cause A Recession What about U.S.-China cooperation on North Korea? It appears as if coordination has improved in the face of a potential conflict. At the peak of tensions this summer, China has offered to implement sanctions, cutting off some trade and joint ventures, while the U.S. has given reassurances about U.S. military intentions in the event of a conflict.7 However, judging by conversations with clients on the mainland, a large gap still exists between U.S. and Chinese perceptions. In particular, Chinese clients pushed back against any implication that China is responsible for reining in North Korea's bad behavior. They highlighted China's emphasis on national autonomy, the idea that every country should be left alone to address its own problems in its own jurisdiction. Otherwise countries should resolve differences through diplomacy and dialogue, conducted as equals. The threat or use of force always makes things worse. The current North Korean situation is, from this perspective, America's fault. The North Koreans pursue nuclear-tipped ballistic missiles in order to deter a U.S. attack, having seen what happened to other nuclear aspirants like Iraq, Syria, and most recently Libya.8 In short, China sympathizes with its formal ally North Korea. It demands peaceful negotiations and denounces the threat of regime change. And it does not believe U.S. officials when they renounce regime change as an option, as Secretary of State Rex Tillerson has recently done. "No one will believe that," one of our clients said, and least of all North Korea. (Quite reasonably, we would add.) This argument reinforces our view that China will not impose crippling sanctions on the North, even if it tries to pressure Pyongyang back to the negotiating table. Since the North cannot be expected to give up its nuclear weapons, the negotiations themselves will be limited from the outset. The U.S. essentially has to accept the status quo, possibly even the perpetual threat of a North Korean nuclear strike. This, in turn, increases the probability that the Trump administration will be disappointed with the outcome. Which is precisely why we expect the U.S. not only to bulk up its military alliance in the region but also to impose more "secondary sanctions" and trade tariffs on China. Sino-American tensions will get harder and harder to manage. While we can foresee skirmishes and violent incidents, we think the probability of a full-scale Second Korean War is low. Diplomacy is not exhausted, the U.S. alliance with regional powers remains intact, and, most importantly, North Korea has not committed an act of war (or acted as if it is about to, which would prompt U.S. preemption). Regarding the big picture, some of our clients are not so sanguine. One of them pointed out recent academic research arguing that armed conflict, as a cause of death in the human population, has declined. The number of violent deaths per 100,000 people has fallen from historic levels in the hundreds down to an average of 60 in the twentieth century, which includes two world wars, and down to the single digits in the post-WWII era (Chart 3). The client asks: Is this drop in war deaths sustainable? The implication is that the level of deaths has nowhere to go but up. Chart 3Human Deaths By War Have Collapsed In Post-WWII Era The client coupled this thought with another bearish theory. It is widely known that recessions are normally preceded by large financial or economic imbalances. Today many investors are encouraged by the apparent lack of any such imbalance. They read this as saying, "let the good times roll." Our client viewed it another way, suggesting that the imbalance that will cause the next major recession will be non-financial and non-economic, e.g. ecological, epidemiological, geopolitical, etc. Chart 4Global Conflicts Increasing In Frequency The client was not specifically hinting at a North Korean conflagration, though probably not ruling it out either. He was mostly concerned with the historic drop in deaths by conflict and how it might be reversed in the near future. Unfortunately this bleak suggestion that war might make a secular comeback is not incompatible with our view that geopolitical multipolarity goes hand in hand with a higher incidence of internationalized conflicts (Chart 4), which could be exacerbated by a decline in global trade. On the other hand, the fall in deaths is a product of a range of political, economic, social and scientific advances, and may not be reversed through geopolitical tensions alone. Bottom Line: The U.S. and China remain far apart in their perceptions of who is to blame for North Korea and what is to be done. China will not take responsibility for "solving" the problem as the U.S. demands. This reinforces our view that North Korean tensions have not yet peaked and remain market-relevant. We ultimately believe that a peaceful solution will prevail, but getting from here (tensions) to there (a negotiated settlement) entails further risks. China Will Try To Reform, But Won't Touch The Property Bubble "They've got to do something about the corporate leverage." This was the conclusion of a client who agreed with our view that President Xi Jinping will likely accelerate his reform agenda after the nineteenth National Party Congress this fall, and that deleveraging is the key indicator (Chart 5). Some clients in China - specifically banks - confirmed that they were under pressure from tightening financial regulation and as a result were both slowing the pace of lending and becoming more scrutinizing of borrowers' creditworthiness. Borrowing rates have ticked up (Chart 6). Chart 5High Time For Some Belt-Tightening Chart 6Chinese Cost Of Capital Ticks Up Clients also suggested that Chinese leaders would soon re-emphasize the country's transition away from GDP targets as a measure of successful governance and economic stewardship. When the Xi administration came to power, it sought to de-emphasize GDP targets and introduced new and alternative targets - such as urban and rural income per capita, labor productivity, corruption, air pollution - into its assessments of economic progress. But the administration was forced to return to GDP targets amid growth fears in 2015, prompting Premier Li Keqiang to promise "at least" 6.5% growth for the next five years. Now the attempt to elevate qualitative measures of governance looks set to resume. Xi held two meetings of the Central Leading Group for Deepening Overall Reform this summer, in which he noticeably prioritized "green growth" rather than plain old growth, and pushed for replicating and applying more broadly the pilot reforms that have been implemented since his reform agenda was first laid out in 2013. In mid-July, at the National Financial Work Conference, Xi called for local officials to be held accountable for local government debt - even beyond their term in office. And in late July, Yang Weimin, a key economic policymaker who reports to Xi, said, "we won't allow the leverage ratio to rise for the sake of maintaining growth."9 The implication is that GDP growth will be allowed to fall as the government attempts to make progress on difficult reform initiatives. Chart 7Bonds More Important In China Several clients also expressed confidence that China would resume economic "opening up" before long. It is well known that, over the past year, Beijing has sought to attract FDI by promising to implement a nationwide "negative list" and removing certain sub-sectors from that list, in a bid to counter recent weak FDI inflows and ongoing capital outflow pressure. Beijing has also taken steps to deepen its financial sector, such as by expanding and regularizing its bond markets (Chart 7) in preparation for opening the Hong Kong-Shanghai "bond connect," which will allow foreign investors to buy Chinese bonds and, we think, generate strong demand. To add to this list, clients stressed that China is beginning to think about what happens after it lifts the capital controls put in place last year to halt outflows. A number of institutions are interested in expanding their overseas portfolios when they get the "all clear." We would expect the re-opening to come after the central government completes a round of reforming, recapitalizing, and restructuring banks and SOEs, which could push the timing well into 2018 or 2019. But clients are clearly chomping at the bit - which may suggest that they anticipate capital controls to be lifted sooner rather than later. One important reform item that we were told not to expect is the imposition of a nationwide property tax. Chinese authorities delayed the implementation of the tax in 2016 due to the desire to reflate the property market. Presumably they will return to this initiative now that the economy has recovered: it makes long-term sense to give local governments a more stable source of revenue and to suck some air out of the property bubble gradually so that it does not burst (Chart 8). However, clients are skeptical about any reforms that could harshly suppress real estate prices due to the heavy concentration of household wealth in the property sector (Chart 9). Chart 8Provinces To Be Weaned Off Of Land Sales? Chart 9Chinese Wealth Stored In Housing If the property bubble should be popped, people's life savings would vanish into thin air and there would be chaos in the streets. A client in Hong Kong remarked that the Chinese public will pretty much accept anything as long as property prices continue to rise. Since everyone agrees that social stability is the critical aim of the ruling party, it stands to reason that reforms will not be allowed to threaten the property sector, at least not directly. If the property sector prevents serious attempts at deleveraging, then the environmental agenda will become all the more significant as the focus of the Xi administration in its second five-year term. The administration began by increasing central government spending for environmental regulation more than for any other category of spending (Table 1). And Xi's statements in July, previewing the National Party Congress, emphasized fighting pollution as one of three chief focal points (the others were controlling systemic risks and fighting poverty). Table 1Fiscal Priorities Of Recent Chinese Presidents In recent months, central inspectors have fanned out across the country to conduct local pollution inspections ahead of end-of-year deadlines. These have fueled market speculation about deep curbs coming to industrial overcapacity, causing the prices of certain commodities that China produces, like aluminum, to surge (Chart 10). These commodity prices have likely already seen the biggest moves - given China's sharp slowdown in 2014 and reflation in 2015-16 - but they are still sensitive to the policy mix in China, i.e. the relative amounts of capacity cuts and deleveraging that take place. Chart 10Supply-Side Reform Has Boosted Metals Bottom Line: Clients across the Asia-Pacific region were focused on the question of Chinese structural reforms. We got the sense that there was much skepticism over whether they would indeed be growth-constraining. But when pushed, clients focused on real estate prices as the one threshold policymakers would not dare to cross in China. What About Japan? A Visit With Mr. K One of our most esteemed clients is a seasoned Japanese global investor who shall go by the moniker of "Mr. K" in the following dialogue (and for future reference). Mr. K opened the dialogue with us by asking us for our view of Japan. Mr. K: What is your view on my country, on Japan? GPS: We tend to think that the current reflationary policy will continue. The Tokyo metropolitan elections did not sound the death knell for Prime Minister Shinzo Abe (Chart 11). The BoJ has become more, not less, dovish, and is not likely to follow other central banks in tightening policy anytime soon. Abe retains control of both houses of the Diet and can increase government spending to boost the economy. And the LDP will continue reflation even if Abe falls. Mr. K: This may be true, reflation will continue. However, the Japanese economy is reaching a plateau after five years of Abenomics. The recent strong GDP numbers were not well-received because consumers feel the stagnation (Chart 12). Global demand, and Chinese demand, have provided a positive backdrop for Japanese manufacturers, but the domestic outlook is not wildly optimistic. Chart 11Abe No Longer In Free-Fall Chart 12Japanese Feel Stagnant Despite Strong Growth With economic policy, the key phrase is "TINA," There Is No Alternative. There is no alternative to Abe at the moment. If you look back at the Democratic Party of Japan's support in 2011 under Prime Minister Yoshihiko Noda, it was a real contender. Today, it is far from rivaling the LDP (Chart 13). The voting population is, apparently, comfortable. It is true that if Abe leaves, it will not make much of a difference, as long as the LDP remains in power. The younger generations do not seem troubled by the current state of affairs. They are well-trained to endure economic stagnation. There is a sense that those who stand out feel uncomfortable. College graduates looking for jobs are very conservative. While with Generation X there was always the expectation that tomorrow would be a brighter day, Generation Millennial has come not only to accept stagnation, but even to like the stability of flat growth. GPS: Isn't this kind of stagnation a good thing? Isn't it a case of Japan being in a "Goldilocks" phase? Mr. K: Stability and stagnation can be good for markets. First, the macro environment is decent. Corporations have large cash balances, external demand is strong, wage demand is subdued, and the exchange rate is weak. However, risk-taking is not prized, whether in the education system or the media. Public discourse tends to discourage high-risk investments. And risk-takers have not been properly rewarded over the past two decades in Japan (Chart 14), so confidence and risk-appetite are weak. Also, deflation is hard to defeat. The "100 Yen Shop" (dollar store) retail model is a good example. The goods are all cheap, but as long as you can bring more people in, you can make a profit. This is almost all deflationary. Moreover, the Japanese have nothing to spend on! They no longer need new cars, or big computers; they just need mobile phones, maybe a Nintendo Switch, etc. Second, as to the financial markets, greater deregulation is necessary to attract non-Japanese capital flows. Maybe then valuations will normalize (Chart 15). It is essential to see if leading companies continue to gain global competitiveness, in anything from Internet services to gaming. Watch valuations and watch cash flow. Chart 13Opposition Still Can't Touch Ruling LDP Chart 14Risk-Takers Punished In Japan Chart 15Japanese Valuations Still Low The key firms are not necessarily the keiretsu, but secondary or new manufacturers that are driving growth. Small caps are more leveraged to foreign exchange, whereas neither the Japanese domestic economy nor the value of the yen matter much to large multinationals anymore. To capitalize on the internal economy you want to be long small caps. Or better yet, long semi-large caps: those companies equivalent to the U.S. companies that make the difference between the S&P 500 and the S&P 600. These are some of the best plays in Japan because they are domestic-oriented and sensitive to the weaker yen. This will provide a tailwind for stocks elsewhere. Local property markets also offer a very good return over the risk-free rate. GPS: What do you make of our view that Abe will push reflationary policy ahead of his efforts to revise the constitution? Given that he needs a strong economy to pass the popular referendum? Mr. K: It is harder to increase fiscal spending in Japan than one might think. However, the North Korean threat is not going anywhere. And the media love "tensions." GPS: So it seems like you are positive about the markets in Japan, but are not yet sold on Abenomics? Mr. K: I suppose the lesson is, if it isn't too cold, stay on the ski slopes. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For this term, please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, as well as Allison's new book, Destined For War: Can America and China Escape Thucydides's Trap? (New York: Houghton Mifflin Harcourt, 2017). 2 Please see BCA China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge," dated August 17, 2017, available at cis.bcaresearch.com. 4 Please see "China cracks down on distribution of illegal publications," Xinhua, July 25, 2017, available at news.xinhuanet.com. China also highlighted the BRICS countries' joint efforts at enforcing intellectual property as it prepared to host the BRICS conference in Xiamen, Fujian in September. Please see Ministry of Commerce, "Ministry Of Commerce Holds Press Conference on 2017 BRICS Trade Ministers' Meeting," August 4, 2017, available at english.mofcom.gov.cn. 5 Please see the Office of the United States Trade Representative, "USTR Announces Initiation of Section 301 Investigation of China," August 2017, available at ustr.gov. 6 Other examples of U.S. cooperation with Chinese initiatives include the U.S. sending a small delegation to take part in the One Belt One Road (OBOR) conference in May. 7 In particular, Chairman of the Joint Chiefs of Staff Dunsford visited China, met with the Central Military Commission, and vowed to improve military-to-military relations. 8 Or a country like Ukraine, which agreed to give up its nuclear arsenal as soon as it became independent in 1994, only to see its territory carved up by global powers 20 years later (13 years after it emptied its missile silos). 9 Please see Sidney Leng, "China shifts gear from growth to debt cuts in race against rising tide of red ink," South China Morning Post, July 27, 2017, available at www.scmp.com. Appendix Table 2Will The U.S. Attack North Korea? Geopolitical Calendar
The latest FDIC Quarterly Banking Profile paints a rosy picture for bank earnings growth. A surge in net interest income drove the industry Q2 net interest margin (NIM) to its highest level in 4 years, and the return on assets to the highest level in 10 years (second and third panels). Should inflation pick up in the back half of the year as we expect, it should be accompanied by a steeper yield curve and further NIM expansion. Encouragingly, noncurrent C&I loans have peaked (bottom panel), a strong signal that the credit cycle has turned positive. Improving credit quality in this largest category of bank credit should have the double impact of raising earnings and encouraging increasing loan growth. In short, this report reinforces our expectation that soaring consumer and business confidence, rising corporate profits and a potential capital spending revival will support the relative outperformance of banks. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
Highlights Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 Chart 2BGlobal Asset Valuations, 1990-2017 Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Monetary Policy: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Fiscal Policy: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Feature Several developments during the past two weeks provided a lot of information about the near-term outlooks for both monetary and fiscal policy. On the monetary front, the minutes from the July FOMC meeting elucidated the trade-off faced by the Fed between low inflation on one hand and easing financial conditions on the other. Then, at last week's Jackson Hole symposium, both Janet Yellen and Mario Draghi expounded on the topic of financial stability and how central bankers incorporate it into their frameworks. On the fiscal front, the dismissal of White House Chief Strategist Stephen Bannon has the potential to alter the Trump administration's legislative agenda for the remainder of the year, making fiscal stimulus more likely. In this week's report we reflect on how all of these developments impact our 6-12 month policy and market views. Monetary Policy From The Minutes: Low Inflation Vs. Easy Financial Conditions The minutes from the July FOMC meeting showed that "some participants [...] argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist." Meanwhile, "some other participants were more worried about the risks arising from [...] the easing in financial conditions that had developed since the Committee's policy normalization process was initiated in December 2015." In other words, the Committee is roughly evenly split into two groups. Those that would rather delay rate hikes until inflation moves higher, and those that think easier financial conditions are reason enough to continue tightening. Those in the dovish group could point to Chart 1 for support. That chart shows that the real fed funds rate is approaching at least one popular estimate of its neutral level. In the Fed's mental framework it is crucial that the real fed funds rate stays below its neutral level because monetary policy must remain accommodative if inflation is to rise back to the 2% target. In other words, the Fed does not have "room" for further rate hikes unless inflation rises first, causing the real fed funds rate to fall. We won't re-hash prior arguments about why core inflation is likely to rise on a 6-12 month horizon,1 but we will note that our diffusion indexes for both PCE and CPI inflation have recently swung into positive territory. These indexes have strong track records capturing the near-term moves in year-over-year core inflation (Chart 2), and this development gives us some confidence that the downtrend in inflation will soon reverse. Chart 1Closing In On Neutral Chart 2A Positive Signal On Inflation While the dovish camp wants to see strength in core inflation before delivering another hike, the hawkish camp views the easing of financial conditions as sufficient to forecast stronger growth and higher inflation in the near future. This view is backed by some solid empirical evidence. Chart 3 shows one measure of financial conditions - the financial conditions component of our Fed Monitor.2 This index performs reasonably well predicting near-term swings in GDP, and at the moment it suggests that growth will accelerate further in the back half of the year. This "financial conditions approach" to policymaking suggests that monetary policy impacts financial markets and that financial market performance then translates into economic outcomes. From this perspective, the fact that financial conditions have continued to ease since the Fed started tightening in December 2015 means that, so far, monetary tightening has not had any impact cooling the economy (Chart 4). Chart 3Financial Conditions##br## Lead Growth Chart 4Financial Conditions Easier, ##br##Despite Fed Tightening To us, this is the crucial point about the arguments made by the hawkish camp. This group focuses on financial conditions because it believes that easier financial conditions will soon lead to stronger growth and higher inflation. The group is not making the case that the Fed should abandon its 2% inflation target because of concerns about stability in financial markets. From Jackson Hole: Financial Conditions Vs. Financial Stability The focus on financial stability at Jackson Hole led many commentators to forecast that the Fed might tighten due to concerns about excessive leverage and risk-taking in financial markets, ignoring progress toward its inflation target.3 We think this is incorrect, and would draw an important distinction between when central bankers talk about "financial conditions" and when they talk about "financial stability". While the two concepts are obviously similar, central bankers tend to focus on financial conditions as a leading indicator for the economy. It is not separate from the 2% inflation target, rather, it is an input to the Fed's growth and inflation forecasts. However, when central bankers talk about financial stability, they are typically referring to an assessment of the amount of risk-taking and leverage in financial markets. If the risk-taking and leverage in financial markets is deemed excessive, it could pose a downside risk to future growth. Currently, central bankers in general do not believe that there is an imminent threat from financial stability. But more importantly, no current prominent central banker has proposed tightening policy to deal with financial stability risks while disregarding the inflation target. Here is what Janet Yellen had to say on the topic at Jackson Hole: I expect that the evolution of the financial system in response to global economic forces, technology, and, yes, regulation will result sooner or later in the all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging in new ways that require policy responses. And Mario Draghi: [W]hen monetary policy is accommodative, lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we have now has enabled economies to endure a long period of low interest rates without any significant side-effects on financial stability[.] The above passages make a couple of points abundantly clear: Neither central banker views financial stability as currently posing an economic risk. The preferred method for dealing with this risk, if it were to arise in the future, would be through macroprudential regulation. That is, regulations that limit leverage and maturity transformation. In fact, Draghi plainly said that a robust regulatory regime is important because it allows central banks to use interest rate policy to manage inflation back to target. Janet Yellen also pointed out in her remarks that financial stability risks in the future will almost certainly emerge in "new ways". This makes these risks much more difficult to detect in real time. Meanwhile, it is comparatively easy for Fed policymakers to look at inflation and judge it relative to the 2% target. This is yet another reason why interest rate policy will continue to be guided by inflationary pressures in the economy, not concerns about financial stability. Put differently, if inflation does not reach the Fed's 2% target before the next recession, that would be an easily quantifiable policy failure. This is an outcome that Fed policymakers will seek to avoid at all costs. Bottom Line: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Financial conditions are an important input to the Fed's growth and inflation forecasts, but the Fed will not tighten policy due to concerns about financial stability alone. Fiscal Policy Judging from the performance of a high tax-rate basket of U.S. stocks, investors appear to have completely priced out any possibility of tax reform (Chart 5). This is likely a mistake. Tax reform is a major component of both President Trump's and congressional Republicans' agendas. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart 5Too Complacent On Tax Cuts? Further, as was recently discussed in depth by our Geopolitical Strategy service,4 until recently the White House had been divided into two cliques. The "Goldman clique", led by National Economic Council Director Gary Cohn, is pragmatic and un-ideological. It is focused on passing tax reform and pro-business regulation. In contrast, the "Breitbart clique" is populist and nationalist. It also leans to the left on economic matters. The recent removal of White House Chief Strategist (and Breitbart clique leader) Stephen Bannon signals a shift in power toward the Goldman clique. Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. This likely points to an increased resolve to push through some sort of tax legislation. While the size of any tax cut is still very much in question, given how little is priced in, it will not take much to move the needle on financial markets. Bottom Line: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation How expensive are corporate bonds compared to history? On its face, a simple question. But one that quickly gets complicated when we dig into the details. Case in point, the top panel of Chart 6 shows the average option-adjusted spread (OAS) on the Bloomberg Barclays Investment Grade Corporate Bond Index going back to 1990. A cursory glance at this chart shows that the OAS is somewhat below its historical average, but also that it has been tighter in the past. But this simple visual obscures a few important factors: The average credit quality of the index has worsened since the financial crisis (Chart 6, panel 2). All else equal, this means the average spread should be wider. The average duration of the index has risen over time as bond yields have fallen (Chart 6, panel). This means that the same change in spreads has a larger return impact today than in years past. The stage of the credit/monetary policy cycle is also important. In the top panel of Chart 6 we see that the OAS does not spend a lot of time near its long-run average. Rather, it tends to be very wide in the negative phases of the cycle and very tight in the positive phases. In past reports we have considered the performance of corporate bonds across the four phases of the Fed cycle (Chart 7). To recap, these phases are defined as follows: Chart 6Corporate Spreads Need To Be Adjusted Chart 7Stylized Fed Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In phases I and IV, we can expect tight spreads and relatively strong excess returns from corporate bonds. Phases II and III are characterized by wider spreads and lower returns. At the moment we judge that we are firmly in phase I of the cycle. The Fed has begun to tighten policy, but by all accounts monetary conditions remain accommodative and the real fed funds rate is below its neutral level (Chart 6, bottom panel).5 Adjusting Corporate Spreads On the first necessary adjustment, we can easily adjust for differences in average credit rating by looking at the different credit tiers of the corporate bond index rather than the index as a whole. As for the second necessary adjustment, we adjust for changes in duration over time by using a 12-month breakeven spread instead of the OAS. The 12-month breakeven spread is defined as the spread widening (in basis points) required over a 12-month period before the given corporate bond index delivers a negative excess return relative to duration-matched Treasuries. It thus includes both the OAS and the impact of lower duration.6 Chart 8 shows 12-month breakeven spreads for each investment grade corporate bond credit tier alongside its historical average and +/- one standard deviation. In each case we observe that breakeven spreads are well below average. In fact, the breakeven spread makes corporate bonds appear slightly more expensive than does the OAS. The final adjustment we need to make is to consider current spreads relative to other similar phases of the Fed cycle. In Chart 9 we show OAS for each credit tier, with dashed lines denoting the historical average, minimum and maximum OAS seen during prior Phase I periods. Adjusting only for credit rating and the stage of cycle (not for changes in duration), we find that Aaa, Aa and A-rated credits appear quite cheap, while Baa-rated credits appear close to fair value. In Chart 10 we show 12-month breakeven spreads for each credit tier relative to other similar phases of the Fed cycle. In other words, the spreads here are adjusted for credit rating, duration and the stage of the cycle. This chart tells a somewhat different story. Here, Aaa-rated credits appear very expensive. Meanwhile, Aa, A and Baa-rated credits appear close to fairly valued. Chart 8Breakeven Spreads Versus Long-Run Average Chart 9Cycle-Adjusted OAS Chart 10Cycle-Adjusted Breakeven Spreads Bottom Line: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 For more details on the Fed monitor, please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2017-08-25/el-erian-says-markets-too-sanguine-about-fed-view-on-instability 4 Please see Geopolitical Strategy Weekly Report, "The Wrath Of Cohn", dated July 26, 2017, available at gps.bcaresearch.com 5 As was stated earlier in this report, the gap between the real fed funds rate and its neutral level will widen as inflation bounces back in the coming months. 6 For simplicity we assume no convexity impact on excess returns. The 12-month breakeven spread is then calculated as OAS divided by duration. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.
