Developed Countries
Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.
Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation Chart 5Domestic Will Beat Global World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Chart 7Sell The Spike Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! Chart 9The Dollar Will Do Damage ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Chart 11... As Fundamentals Erode Chart 12Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play Chart 14Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The previous Insight showed that the fundamental backdrop is shifting decisively in favor of domestic vs. globally-oriented equities. That is a major plus for U.S. small vs. large caps. In fact, a broad-based and powerful rotation into small caps already appears to be getting underway, as all the major small cap sectors have surged relative to their large cap counterparts of late. While there may be some tactical downside risk given the scope of the small cap spike, a strong U.S. dollar and likelihood of renewed emerging market financial strains argue for riding out any volatility and maintaining a core overweight in the small cap asset class. It would take evidence of a reversal in the small vs. large cap profit outlook to trigger a downgrading in our view, as discussed in previous research reports.
One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Protectionist rhetoric and/or policies would only serve to undermine trade. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries.
Highlights Tighter global oil markets resulting from the production cut we expect to be announced November 30 at OPEC's Vienna meeting, along with fiscal stimulus from the incoming Trump administration in the U.S., will continue to stoke inflation expectations. We believe gold is well suited for hedging investors' medium-term inflation exposure, given its sensitivity to 5-year/5-year CPI swaps in the U.S. and eurozone. If the Fed decides to get out ahead of this expected pick-up in inflation and inflation expectations by raising rates aggressively next year, we would expect any increase in gold prices - and oil prices, for that matter - to be challenged. For OPEC and non-OPEC producers, a larger production cut may be required to offset a stronger USD next year. Near term, we still like upside oil exposure, given our expectation that production will be cut. Energy: Overweight. We remain long Brent call spreads expiring at year-end, and long WTI front-to-back spreads in 2017H2, in anticipation of an oil-production cut. Base Metals: Neutral. We expect nickel to outperform zinc in 2017. Precious Metals: Neutral. We are long gold at $1,227/oz after our buy-stop was elected on November 11. We are including a 5% stop-loss for this position. Ags/Softs: Underweight. Our long Mar/17 wheat vs. beans order was filled on November 14. We still look to go long corn vs. sugar. Feature Chart of the WeekBrent, WTI Curves Will Flatten, ##br##Then Backwardate Following Oil-Production Cut Continuing production increases from sundry sources outside OPEC, which the International Energy Agency estimates will lift output almost 500k b/d in 2017, are turning the heat up on the Kingdom of Saudi Arabia (KSA) and Russia to agree a production cut at the Cartel's meeting in Vienna later this month. It's either that or risk another downdraft that takes prices closer to the bottom of our long-standing $40-to-$65/bbl price range that defines U.S. shale-oil economics. The unexpected strength in production growth outside OPEC likely will require KSA and Russia to come up with a production cut that exceeds the 1mm b/d we projected earlier this month would be required to lift prices into the mid-$50s/bbl range. On the back of the expected cuts, we recommended getting long a February 2017 Brent call spread - long the $50/bbl strike vs. short the $55/bbl strike at $1.21/bbl. As of Tuesday's close, when we mark our positions to market every week, the position was up 9.09%. Reduced output from KSA and Russia - and, most likely, Gulf allies of KSA - will force refiners globally to draw down crude in storage, and for refined product inventories to draw as well. This will lift the forward curves for Brent and WTI futures (Chart of the Week). We expect oil prices will increase by approximately $10/bbl, following the joint cuts of 500k b/d each we expect KSA and Russia, which will be announced November 30. This also will lift 3-year forward WTI futures prices, which, as we showed in previous research, share a common trend with 5y5y CPI swaps. As stocks continue to draw next year, we expect the forward Brent and WTI curves to flatten, and, in 2017H2, to backwardate - that is to say, prompt-delivery prices will trade above the price of oil delivered in the future. For this reason, we are long August 2017 WTI futures vs. short November 2017 WTI futures, expecting the price difference between the two, which favors the deferred contract at present (i.e., a contango curve), to flip in favor of the Aug/17 contract. Chart 2Longer-dated WTI Futures, ##br##Inflation Expectations Rising Fiscal Stimulus Expected in the U.S. The election of Donald J. Trump as the 45th president of the U.S. likely will usher in significant fiscal stimulus beginning next year, particularly as Republicans now control the Presidency and Congress for the first time since 2005 - 06, when George W. Bush was president. Trump campaigned on a promise of significant fiscal stimulus, which likely will, among other things, stoke inflation expectations as money starts to flow to infrastructure projects and tax cuts toward the end of next year. Even before Trump's election 5-year/5-year (5y5y) CPI swaps were ticking higher, as oil markets rebalanced and started to discount the drawdown in global inventories this year and next (Chart 2). As the outlines of the Trump administration's fiscal policy take shape and money starts to flow to infrastructure projects, we expect inflation expectations to continue to rise. In previous research, we showed 5y5y CPI swaps and 3-year forward WTI futures are cointegrated, meaning they follow the same long-term trend. Indeed, we can specify 5y5y CPI swaps in the U.S. and eurozone directly as a function of 3-year forward WTI futures.1 Gold Will Lift With Rising Inflation Expectations... In the post-Global Financial Crisis (GFC) markets, gold prices have shared a common trend with U.S. CPI 5y5y swaps and real interest rates, which we show in a new model (Chart 3A, top panel).2 Using this specification, we find a 1% increase in the U.S. 5y5y CPI swaps increases gold prices by slightly more than 9%. Similarly, we find a 1% increase in EMU 5y5y CPI swaps increases gold prices by slightly more than 10% (Chart 3B, top panel).3 Of course, investors always can go straight to Treasury Inflation Protected Securities (TIPS) for inflation protection, given the evolution of the respective CPIs in the U.S. and eurozone drives returns for these securities (Chart 4). However, we believe gold gives investors higher leverage to actual inflation and expected inflation. Chart 3AGold Prices Ticking Higher With ##br##U.S. CPI Inflation Expectations Chart 3BEMU Inflation Expectations ##br##Vs. 3-year Forward WTI Chart 4Inflation Expectations And TIPS ##br##Are Highly Correlated, As Well ...But The USD's Evolution Matters, Too The combination of tighter oil markets and fiscal stimulus in the U.S. will continue to push inflation and inflation expectations higher. The Fed will not sit idly by and just watch inflation expectations move higher next year. Indeed, prior to the election, we expected two rate hikes next year, following a likely rate increase at the FOMC's meeting next month. With expectations of a tightening oil market, and a fresh round of fiscal stimulus from the incoming Trump administration, the odds of an even stronger USD increase. We had been expecting the USD will appreciate 10% over the next year or so, as a result of the upcoming December rate hike and two additional hikes next year. This could change, since, as, our Foreign Exchange Strategy service noted, "Trump's electoral victory only re-enforces our bullish stance on the dollar."4 A stronger USD, all else equal, is bearish for commodities generally, since it raises the cost of dollar-denominated commodities ex-U.S., and lowers the costs of commodity producers in local-currency terms. The former effect depresses demand at the margin, while the latter raises supply at the margin. Both effects would combine to reduce oil prices at the margin (Chart 5). This would, in turn, lower inflation expectations, which would feed into lower gold prices (Chart 6). Chart 5A Stronger USD Would Be Bearish For Oil Chart 6And Gold Prices As It Would Lower Inflation Expectations Our FX view, is complicated by the possibility the Fed might want to run a "high-pressure economy" next year, and the potential for additional Chinese fiscal stimulus going into the 19th Communist Party Congress next fall. If both the U.S. and China deploy significant fiscal stimulus next year, the growth in these economies could overwhelm the negative effects of a stronger USD, and industrial commodities - chiefly base metals, iron ore and steel - could rally as demand picks up. Oil demand also would be expected to pick up as a result of the combined fiscal stimulus coming out of the U.S. and China, both from infrastructure build-outs and income growth. KSA - Russia Oil-Production Cut Gets Complicated These considerations will complicate the calculus of KSA and Russia and their respective oil-producing allies as the November 30 OPEC meeting in Vienna draws near. If the Fed moves to get out ahead of increasing inflation expectations by adding another rate hike or two next year, oil prices will encounter a significant headwind. OPEC and non-OPEC producers could very well find themselves back at the bargaining table negotiating additional cuts, as prices come under pressure next year from higher U.S. interest rates. It is too early to act on any speculation regarding fiscal policy in the U.S. or China next year. However, given our expectation for an oil-production cut announcement later this month at OPEC's Vienna meeting, we are confident staying long the Brent $50/$55 call spread, and the long Jul/17 vs. short Nov/17 WTI spread position we recommended earlier this month. As greater clarity emerges on U.S. and Chinese fiscal policy going into next year, we will update our assessments. Bottom Line: We expect global oil markets to tighten as KSA and Russia engineer a production cut, which will be announced at OPEC's Vienna meeting later this month. Fiscal stimulus from the incoming Trump administration in the U.S., and possible fiscal stimulus in China next year could put a bid under commodities. However, if the Fed gets out ahead of the expected pick-up in inflation and inflation expectations by raising rates aggressively next year, any increase in commodity prices - oil and gold, in particular - will be challenged. KSA and Russia could find themselves back at the bargaining table, negotiating yet another production cut to offset a stronger USD. That said, we are retaining our upside oil exposure via a Brent $50/$55 call spread expiring at the end of this year, and our long Jul/17 WTI vs. short Nov/17 WTI futures, which will go into the money as the forward curve flattens and then goes into a backwardation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Nickel: A Good Buy, Especially Versus Zinc Chart 7Nickel: More Upside Ahead We are bullish on nickel prices, both tactically and strategically. Its supply deficit is likely to widen on rising stainless steel demand and falling nickel ore supply in 2017. China will continue to increase its refined nickel imports to meet strong domestic stainless steel production growth. We remain strategically bearish zinc even though our short Dec/17 LME zinc position got stopped out at $2500/MT with a 4% loss. We expect nickel to outperform zinc considerably in 2017. We recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Nickel prices have gone up over 50% since bottoming in February (Chart 7, panel 1). The global nickel supply deficit reached a record high of 75 thousand metric tons (kt) for the first eight months of this year, based on the World Bureau of Metal Statistics (WBMS) data (Chart 7, panel 2). More upside for nickel in 2017 On the supply side, the outlook is not promising in 2017. Global nickel ore and refined nickel production fell 5.2% and 1.1% yoy for the first eight months of this year, respectively, according to the WBMS data (Chart 7, panel 3). The newly elected Philippine government is clearly aiming for "responsible mining," and has been highly restrictive on domestic nickel mining activities, actions that likely will reduce the country's nickel ore production in 2017. The Philippines became the world's biggest nickel ore producer and exporter after Indonesia banned nickel ore exports in January 2014. The Philippines has implemented a national audit on domestic mines from July to September and has halted 10 mines for their environmental violations since July. Eight of them are nickel producers, which account for about 10% of the country's total nickel output. In late September, the government further declared that 12 more mines (mostly nickel) were recommended for suspension, and 18 firms are also subject to a further review. Stringent policy oversight will be the on-going theme for Philippine mines. We expect more suspensions in the country next year. There is no sign the export ban will be removed by the Indonesian government. Since Indonesia banned nickel ore exports in January 2014, the country's nickel ore output has declined 84% from 2013 to 2015. This occurred even though smelters were built locally, which will allow more nickel ore output in Indonesia. However, the incremental Indonesian output is unlikely to make up for the global nickel ore shortage next year. Global nickel demand is on the rise again (Chart 7, panel 4). According to the International Stainless Steel Forum (ISSF), global stainless steel production grew by 11.5% in 2016Q2 from only 3.7% yoy in 2016Q1. Comparatively, in 2015, the growth was a negative 0.3%. Due to fiscal and monetary stimulus in China this year, we expect continued growth in global stainless steel production in 2017. Why China Is Important To Global Nickel Markets China is the world's biggest nickel producer, consumer and importer. Its primary effect on nickel prices is through refined nickel imports. It also influences global stainless steel prices through stainless steel exports. In comparison to the global supply deficit of 75 kt, the deficit in China widened to 346 kt for the first eight months of this year - the highest physical shortage ever (Chart 8, panel 1). China has driven the global growth of both refined nickel production and nickel consumption since 2010 (Chart 8, panels 2 and 3). During the first eight months of this year, Chinese nickel production dropped sharply to 40.5 kt, nearly three times the global nickel output loss of 13.6 kt. For the same period, China's nickel demand growth accounted for 67% of global growth. In addition, the country produces about 53% of global stainless steel and exports about 10% of domestic-made stainless steel products to the rest of world (Chart 8, panel 4). Clearly, China is extremely important to both the global stainless steel and nickel markets. China Needs To Import More Nickel in 2017 Looking forward, China is likely to continue increasing its nickel imports to meet a growing domestic supply deficit (Chart 9, panel 1). The country's ore imports have been declining because of Indonesia's ban since 2014, and further dropped this year on the Philippine's suspensions (Chart 9, panel 2). Scarcer ore supply drove down Chinese refined nickel and nickel pig iron (NPI) output every year for the past three consecutive years (including this year). Chart 8China: A Key Factor For Nickel Market Chart 9Chinese Nickel Imports Are Set To Rise Prior to 2014, China imported nickel ores from Indonesia to produce NPI, which is used in its domestic stainless steel production. In 2013, only 20% of domestic nickel demand was met by unwrought nickel imports. After 2014, China's higher nickel ore imports from the Philippines were not able to make up the import losses from Indonesia (Chart 9, panel 3). As a result, in 2015, the percentage of domestic nickel demand met by unwrought nickel imports jumped to 47%. Furthermore, for the first eight months of this year, imports accounted for 57% of Chinese demand. Before the Indonesian ban in 2014, Chinese stainless steel producers and NPI producers built up mammoth nickel ore inventories for their stainless steel ore NPI production (Chart 9, panel 4). Now, Chinese laterite ore inventories are much lower than three years ago. Plus, most of the inventories likely are low nickel-content Philippines ore. Besides the tight ore inventory, China's stainless-steel output is accelerating. According to Beijing Antaike Information Development Co., a state-backed research firm, for the first nine months of 2016, Chinese nickel-based stainless steel output grew 11.3% yoy, a much stronger growth rate than the 4% seen during the same period last year. Given falling domestic nickel output and increasing nickel demand from the stainless steel sector, China seems to have no other choice but to import more refined nickel or NPI from overseas. Downside Risks Nickel prices could fall sharply in the near term if massive LME inventories are released to the global market. After all, global nickel inventories currently are at a high level of more than 350 kt, which is more than enough to meet the supply deficit of 75 kt (Chart 10, panel 1). However, as prices are still at the very low end of the range over the past 13 years, we believe that the odds of a massive, sudden inventory release is small. Inventory holders will be hesitant to sell their precious inventory too quickly, therefore the inventory release will likely be gradual, especially given the continuing export ban in Indonesia and a likely increase in the suspension of mines in the Philippines. In the longer term, if Indonesian refined nickel output continues growing at the pace registered in the past two years, the global nickel supply deficit may be much less than the market expects (Chart 10, panel 2). In that scenario, nickel prices will also fall. Due to power supply shortages, poor infrastructure and funding problems, many of the smelters and stainless steel plants' development have got delayed, so we believe these problems will continue to be headwinds for Indonesian nickel output growth. A five-million capacity stainless steel project, funded by three Chinese companies, potentially making Indonesia the world's second biggest stainless steel producer, will only be in production by 2018. Therefore, we believe next year is still a good window for a further rally in nickel prices. In addition, global stainless steel output may weaken again after this year's stimulus from China runs out of steam, which will also weigh on nickel prices (Chart 10, panel 3). We will monitor these risks closely. Investment strategy We expect nickel to outperform zinc considerably in 2017. Nickel has underperformed zinc massively since 2010 with the nickel/zinc price ratio tumbling to a 17-year low (Chart 11, panel 1). Chart 10Downside Risks To Watch Chart 11Nickel Likely To Outperform Zinc In 2017 Even though our short Dec/17 LME zinc position was stopped out at $2500/MT with a 4% loss due to the short-term turbulence, we remain strategically bearish zinc, as we expect supply to rise in 2017 (Chart 11, panel 2).5 Given our assessments of the nickel and zinc markets, we recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38) (Chart 11, panel 3). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Our updated estimates of the cointegrating regressions for U.S. and eurozone 5y5y CPI swaps indicate 3-year forward WTI futures explain close to 87% of the U.S. swap levels and 82% of the eurozone swaps, in the post-GFC period (January 2010 to present). Please see Commodity & Energy Strategy Weekly Report "Inflation Expectations Will Lift As Oil Rebalances," dated March 31, 2016, available at ces.bcaresearch.com. 2 We also found that, over a longer period encompassing pre-GFC markets, gold prices shared a common trend with U.S. 5y5y CPI swaps, as well. Indeed, the evolution of 5y5y CPI swaps explained 84% of gold's price from 2004, when the 5y5y CPI swap time series begins, to present. 3 Previously, we estimated a gold model using the Fed's core PCE and the St. Louis Fed's 5y5y U.S. TIPS inflation index and found a 1% increase in the core PCE translates to a 4% increase in gold prices. Please see Commodity & Energy Strategy Weekly Report "A 'High-Pressure Economy' Would Be Bullish For Gold," dated October 20, 2016, available at ces.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report "Reaganomics 2.0?," dated November 11, 2016, available at fes.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report for zinc section "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades
Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following Chart I-10Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. 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 1-13 * 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 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. 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