Economy
Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Does the 3% level on Treasuries matter to investors? The 2/10 yield curve is typically much steeper when global growth is strong and pro-growth policies are in place. The imperfect inter-relationship between labor market slack, wages and inflation. Feature In last week's report1 we noted that the risk of weakness in equity markets was elevated in the near term. Risks assets balked as the 10-year Treasury yield climbed above 3% early last week. However, easing tensions on the Korean peninsula and another stronger than expected batch of Q1 earnings reports boosted U.S. equity prices later in the week. We will provide a full update on the Q1 earnings season in next week's report. Investors are getting used to a seasonal dip in Q1 U.S. GDP data, and last Friday's release certainly fits the bill. A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this seasonal anomaly are in the private investment and government consumption components of GDP. Output in both categories slowed significantly in Q1 2018. Consumer spending growth exhibited the most significant slow-down, growing at only 1.1% compared to 4% in the prior quarter. But growth in investment spending on equipment also declined sharply, from 11.6% to 4.7%, as did growth in residential investment, from 12.8% to 0% (Chart 1). The latter is due to the sharply accelerating input costs (e.g. lumber prices) faced by homebuilders at the moment. Federal government spending slowed to a 1.7% rate in Q1 from 3.2% in Q4 2017. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target At 2.9% year-over-year in Q1 2018, real economic growth was above the Fed's view of potential GDP (1.8%) for the fifth consecutive quarter. Given the recent seasonal pattern and the substantial fiscal stimulus coming on stream, the Fed will likely see through the weaker Q1 growth data for the time being. Chart 2Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's view is that the 3% level on the 10-Year Treasury yield is not an impediment to higher equity prices. The 10-year yield and U.S. equity prices climbed together in the 1950s. The rise in yields in the '50s primarily reflected better economic growth rather than fears of inflation. The run-up in yields since the lows last year reflect both factors (Chart 2). Nonetheless, investors are concerned that higher yields will flip the positive correlation between bond yields and stock prices. Charts 3 and 4 shows the link between the level of both nominal (Chart 3) and real bond yields and equity prices. The implication is that the relationship between stock prices and bond yields tends to stay positive when the nominal bond yield is below 5%. Furthermore, the correlation between real yields and stock prices remains positive (Chart 4). Moreover, since 1980, a move from 2% to 3% on the 10-year Treasury yield has been accompanied by an average gain of 1.2% in the S&P 500, with a median move of 1.8%.3 On average, the S&P 500 posted a modest decline (24 bps) as the 10-year Treasury elevated from 3% to 4%, but the median return (98 bps) was still positive. Our July 2015 Special Report4 explored the impact of rates and inflation on equity prices. Historically, even the move from 4% to 5% on the 10-year is not an impediment to higher stock prices. Chart 3Stock To Bond Correlations Remain Positive With Nominal Yields Below 5% Chart 4Both Equities And Real Bond Yields Reflect Growth Bottom Line: BCA's stance is that the stock-to-bond ratio will climb this year. Our U.S. Bond Strategy team pegs fair value on the 10-year at 2.78%, but notes that the yield may peak this cycle at between 3.25% and 3.50%.5 BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until at least mid-2019 and that increasing bond yields are not a threat. Yield Curve Dynamics Does BCA's stance on the yield curve change our upbeat view on risk assets beyond the next few months of caution?6 In March,7 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. Although global growth has peaked,8 we expect the era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.9 The curve should resume its flattening trend after that, but will not invert this year. The 2/10 curve stands at 45 bps as of April 27, 2018. Chart 5 shows that the curve has spent very little time in the 0-50 range in the past 35 years when fiscal, monetary and regulatory factors were aligned and global growth was positive. A steeper curve (50 to 100 bps) developed alongside a pro-growth policy and solid global growth only once in the past 35 years, over 1983 and 1984, and never when the 2/10 curve was between 0 and 100 bps (not shown). Chart 5The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place Bottom Line: The backdrop of accommodative fiscal and monetary policy, attended by easing regulatory policy and positive global growth, will continue to provide a tailwind for risk assets through next year. However, the 2/10 yield curve is typically much steeper when these policies are all aligned. Thus, investors should continue to favor equities over bonds and remain underweight duration over the cyclical horizon with a tactical cautious stance over the next few months. The Wage Puzzle Chart 6Economy At Full Employment, Theoretically The move higher in the 10-year Treasury yield to 3% for the first time since 2013 (and the 2-year Treasury to 2.5% for the first time since 2008) has diverted attention to the Fed and inflation. Core CPI is now at the Fed's 2% target and the market is concerned that inflation will shoot past 2% and quickly escalate to 3%. BCA's view is that inflation will remain at the Fed's target this year, but drift above that goal in 2019, which would elicit a more aggressive response from the central bank. Tighter monetary policy will ultimately end the expansion in early 2020.10 Until then, the markets will focus on the drivers of inflation, including wages. Our work11 notes that inflation is slow to turn higher in long expansions. The U.S. economy reached full employment in late 2016 (Chart 6). In short- and medium-length expansions, it takes only a few months before inflation turns up. However, in long expansions (1960s, 1980s, and 1990s) prices did not turn meaningfully higher until 26 months after the economy reached full employment. This suggests that a more significant hike in inflation - led by a tighter labor market - is close and supports the recent rise in Treasury yields. There is mixed evidence that view is warranted. Wage inflation has moved higher in recent months, but the link between wages and prices has weakened. Chart 7 shows that before 1985, the correlation between wage growth and prices was above 90%. Since 1984, the relationship has waned. The post-1985 correlation is just under 30%. BCA expects this weaker relationship to persist. Chart 7Link Between Wage Inflation And Consumer Inflation Changed After 1985 The disconnect between labor market tightness and wages has recently widened. Chart 8 shows several measures of wage pressures and labor market slack. Historically, less slack translates into higher wages, but the relationship in this cycle has been muted. Moreover, pay gains for workers who switch jobs are running well ahead of those who stay in their current positions and are either promoted or given merit raises (Chart 9). The gap between compensation gains of job switchers and job stayers tends to broaden as the business cycle ages and slack in the labor market shrinks. Chart 8A Wide Disconnect Between Labor Market Slack And Wage Gains Chart 9Job Switchers Seeing Better Raises Demographics and wage rigidity dynamics are also at play. Chart 10 shows that the labor force participation rate is headed lower due to demographics, but recent trends suggest there may be improvements in the coming years. BCA's view is that the participation rate will be flat in the next 12 months and move lower in the coming decade. Chart 10Decline In Labor Force Participation Is Mostly Demographics Wage inflation is an early career phenomenon. Recent research from the Federal Reserve Bank of New York12 shows that across all education cohorts, rapid real wage growth occurs early in a worker's career, with positive real wage growth ending in his/her forties. This is followed by a period of flat to declining real wages. By age 55, all education categories experience negative real wage growth, on average (Chart 11). Chart 11Wage Inflation Is An Early Career Phenomenon Wage rigidity in this cycle suggests that there will be an upward correction in labor compensation. Chart 12 shows that 14.5% of workers did not have wage increases in 2017. Moreover, 18.9% of hourly workers and 9.2% of non-hourly workers saw no increase in pay in the year ending in December 2017 (Chart 13, top panel.) The bottom panel of Chart 13 shows that more than 20% of workers with less than a high school education received no pay increases in the past year; only 10% of college-educated workers experienced the same end. It is important to note that on balance, measures of wage rigidity have increased over time and are not overly sensitive to the business cycle. Chart 12More Than 14% Of Workers Didn't See A Raise In 2017 Chart 13Wage Rigidity By Type Of Employee Bottom Line: BCA recommends that investors monitor a broad range of inflation indicators. Historical evidence suggests that when the labor market tightens, inflation eventually accelerates. However, wages do not always lead inflation at bottoms and maybe a lagging indicator in this cycle.13 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. Most of these indicators show that inflation pressures are building, but only gradually. We expect the Fed to raise rates gradually in the next 12 months, but it may turn more aggressive in 2019 as pressures on inflation, driven in part by a tighter labor market, begin to mount. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 2 https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201706-lingering-residual-seasonality-in-gdp-growth.aspx 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Yellen's Last Week," published February 5, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report, "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Report, "It's Still All About Inflation", January 16, 2018. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", March 12, 2018. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Peril?", April 9, 2018. Available at usis.bcaresearch.com. 9 Please see BCA U.S. Bond Strategy Weekly Report, "Back To Basics", April 17, 2018. Available at usbs.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000", published March 30 2018. Available at gis.bcaresearch.com. 11 Please see BCA Research's The Bank Credit Analyst Monthly Report, March 2017. Available at bca.bcaresearch.com. 12 FRBNY: Liberty Street Economics, "U.S. Real Wage Growth: Slowing Down With Age," September 28, 2016. 13 Please see BCA Research's The Bank Credit Analyst, September 2017. Available at bca.bcaresearch.com.
Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Chart 10Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Chart 14Softening Demand Chart 15Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)
Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey Chart 17Only The Best Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Both the euro's undervaluation and the euro area's massive trade surplus constitute disequilibria, which cannot persist in the long term. Hence, the trade-weighted euro will structurally appreciate... ...and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Feature Yanis Varoufakis, the former Finance Minister of Greece, recently highlighted EU institutions' obsession with protecting their credibility at all costs. Once set on a course, EU institutions tend to suffer a blinkered tunnel-vision. A big fan of Shakespeare, Varoufakis likened this resistance to change course - no matter the repercussions - to Lady Macbeth's declaration that "what's done cannot be undone."1 As Mario Draghi prepares to take the stage again, we recall the final line of his last performance on March 8 as an echo of Lady Macbeth. Asked to justify the ECB's obsession with the 2 per cent inflation point-target, Draghi declared that "there are serious costs about changing course on credibility". We fully understand the ECB's desire to protect its credibility. The trouble is that it is set on a course that is incredibly difficult to accomplish: a single mandate to sustain a 2 per cent inflation point-target, based on a consumer price basket that omits one of the largest items of household expenditure - housing itself. Chart of the WeekAs The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Euro Area Inflation Is Running Higher Than The HICP Suggests Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses. Which makes the omission of this cost from the euro area Harmonized Index of Consumer Prices (HICP) completely ludicrous. Using the experience of U.S. inflation which does include owner occupiers' housing costs, we estimate that a price basket that correctly included home maintenance costs would outperform the HICP by an average of 0.5 percentage points a year (Chart I-2). Chart I-2Including Owner Occupiers' Housing Costs ##br##Adds 0.5% To Inflation Recognizing this error, the U.K.'s Office For National Statistics recently changed its main inflation index from the Consumer Prices Index (CPI) to the Consumer Prices Index including owner occupiers' housing costs (CPIH), acknowledging that "the costs of housing services associated with owning, maintaining and living in one's home are an important component of household expenditure that are not included in the CPI... Therefore the CPIH is the most comprehensive measure of inflation." We expect the BoE's target for 2 per cent inflation to switch eventually to the CPIH too, albeit it remains the CPI for the time being. However, a 1 to 3 per cent 'variation band' around the CPI inflation target does give the BoE considerable breathing space. By comparison, the ECB's target for 2 per cent inflation excluding owner occupiers' housing costs and excluding a variation band gives it a significantly more difficult task than its peer central banks. The crucial point is that the ECB's ultra-loose policy is to a large extent a function of a tunnel-vision pursuit of an HICP inflation rate which significantly understates true inflation. As true inflation is higher than suggested, it means that true real interest rates are lower than suggested. And as currency markets feel true real interest rate differentials - rather than those derived from the faultily constructed HICP - it means that markets have undervalued the euro. This has resulted in an over-competitive euro area, and a massive trade surplus (Chart I-3). Chart I-3The Euro Area Trade Surplus Is A Mirror-Image ##br##Of The Undervalued Euro Both the currency undervaluation and the associated trade surplus constitute disequilibria, which cannot persist in the long term. We have no strong conviction for the very near term move in the euro, but there are two longer term implications: the trade-weighted euro will structurally appreciate by about 10%; and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart of the Week). Japanese Lessons For Europeans: The Homework A few weeks ago in Japanese Lessons For Europeans we made some counterintuitive observations about Japan's post-bubble economic experience.2 Most notably, we showed that on a real GDP per head basis, Japan has outperformed every other major economy over the past twenty years. Our finding was based on real GDP divided by working age (15-64) population because we wanted to capture real productivity gains - which rely mainly on the productive population. The counterintuitive finding elicited a couple of questions. One question was whether the result changes if we were to divide by the total population rather than the working age population. The answer is, not really. Dividing by total population, Japan would no longer be top of the leader board, but the broad result would still hold. Japan has performed impressively, and we fail to see the so-called 'lost decades' (Chart I-4 and Chart I-5). Chart I-4Japan Has Performed Impressively On ##br##Real GDP Per Working Age Population... Chart I-5...And Real GDP Per##br## Total Population Still, some people pointed out that Japan's public indebtedness now equals 210% of its GDP, up from 120% at the start of the century. So a second question was whether Japan's impressive performance is entirely due to its fiscal largesse. The answer is, not exactly. What matters is the change in total indebtedness - public plus private. As a share of GDP, public indebtedness is up by 90% but private indebtedness is down by 40%. So total indebtedness is up by 50% of GDP, considerably less than the increases elsewhere in the developed world. For example, over the same period, the U.K.'s total indebtedness is up by 100% of GDP. Moreover, even the level of Japan's total indebtedness as a share of GDP - at 370% - is not that different to other major economies. In Belgium, it is 340%; in France it is 305%; in Canada it is approaching 300% (Charts I-6-Chart I-17). Chart I-6Japan: Total Debt Up From 315% ##br##To 370% Of GDP Chart I-7U.S.: Total Debt Up From 185% ##br##To 250% Of GDP Chart I-8Canada: Total Debt Up From 225%##br## To 290% Of GDP Chart I-9Australia: Total Debt Up From 150% ##br##To 235% Of GDP Chart I-10U.K.: Total Debt Up From 180%##br## To 280% Of GDP Chart I-11Switzerland: Total Debt Up From 245%##br## To 270% Of GDP Chart I-12Germany: Total Debt Down From 185%##br## To 180% Of GDP Chart I-13France: Total Debt Up From 190%##br## To 305% Of GDP Chart I-14Italy: Total Debt Up From 195%##br## To 265% Of GDP Chart I-15Spain: Total Debt Up From 165% ##br##To 270% Of GDP Chart I-16Belgium: Total Debt Up From 260% ##br## To 340% Of GDP Chart I-17Sweden: Total Debt Up From 210% ##br##To 275% Of GDP Public Sector Leveraging Must Counterbalance Private Sector Deleveraging People who take on debt tend to be young, while those who pay down debt tend to be older. As population pyramids in developed economies shift to older cohorts, there are fewer people who wish to take on debt and more people who wish to pay it down. Specifically, the 50-70 age cohort tends to use pre-retirement income and retirement lump-sum payments to extinguish any outstanding mortgage debts. Consider an older person with an income of €1000 who wishes to pay down €100 of debt. It follows that the person will spend €900. Ordinarily, the banking sector will then reallocate the paid-down €100 to, say, a younger person who wants to borrow it. When the borrower spends the €100, aggregate expenditure totals €1000, which equals the original income. And all is well and good. However, in a world where there is an excess of people who wish to pay down debt versus those that wish to borrow, it might not be possible to reallocate the paid-down €100 to a new borrower in the private sector, even with interest rates at ultra-low levels. In this case, the only way to prevent a contraction in expenditure - a recession - is if the government steps in to borrow and spend the aforementioned €100 to keep the economy's expenditures at €1000. Moreover, because the private sector is paying down debt, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. The above illustration describes the structural situation in many developed economies at the moment. And it explains why we should not look at the evolution of indebtedness in the public sector and the private sector separately, but rather in combination. This is another important Japanese lesson for Europeans. A final observation is that if the private sector is deleveraging, private indebtedness as a share of GDP tends to drift lower. This necessarily means that banks total assets' are growing slower than overall sales in the economy. As banks' asset growth is their main driver of long-term profit growth, it also means that banks struggle to outperform the market on a sustained basis. This has been the experience in Japan since 1990 and in the euro area since 2008 (Chart I-18). Chart I-18When The Private Sector Pays Down Debt, Banks Structurally Underperform With private indebtedness declining as a share of GDP in many major economies, we conclude that banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From Yanis Varoufakis's 2018 Rose Shakespeare Lecture. 2 Please see the European Investment Strategy Weekly Report "Japanese Lessons For Europeans" April 5, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a mixed week for our trades. Long USD/ZAR is approaching the end of its 3 month maximum holding period comfortably in profit. Against this, the recent intense volatility in the metals market closed the pair-trade long lead/short nickel at its stop-loss. We are not initiating any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-19 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Table 1Exit Checklist Table 2Protectionism: Upcoming Dates To Watch Chart 2Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Chart 6Beige Book Commercial##BR##Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book