Fixed Income
Highlights Investors are understating the risks that the Trump administration will enact protectionist trade policies. Contrary to popular belief, the economic costs to the U.S. of a protracted "trade war" would be low. The geopolitical impact, however, would be much more sizeable, as would the impact on S&P 500 profits. The near-term risks to global equities are on the downside, although firmer growth in developed economies should provide support to stocks over a 12-month horizon. Global bond yields will be higher this time next year, as will the dollar. The yen is especially vulnerable. We are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. Feature They come over here, they sell their cars, their VCRs. They knock the hell out of our companies. - Donald Trump in an interview with Oprah Winfrey discussing trade with Japan, 1988 Making Tariffs Great Again Donald Trump has flip-flopped on many issues. On trade, however, he has been perfectly consistent. As the quote above demonstrates, Trump has been advocating mercantilist policies ever since he entered the public spotlight in the 1980s. Even in the unlikely event that he wanted to pivot on this issue, he would be hard-pressed to do so. The Republican establishment and most Democrats will hate him no matter what he does. If Trump backpedals from his hardline stance on trade and immigration, he will lose a large chunk of his white, working-class base (Chart 1). One might argue that Trump would have no choice but to adopt a more conciliatory tone if the imposition of protectionist trade policies were to push the U.S. into a recession. However, contrary to widespread opinion, it is far from obvious that this would happen. While rising protectionism would have a major negative effect on many other economies, the impact on the U.S. would be modest, even if other countries were to match higher U.S. tariffs with retaliatory measures. Keep in mind that the U.S. is a relatively closed economy, with exports totaling only 12% of GDP. Exports to China and Mexico amount to 0.9% and 1.4% of GDP, respectively. And much of these exports are intermediate goods that are processed and reshipped back to the U.S. or some other third market. It would not make sense for China or Mexico to put up import barriers on these intermediate goods because this would just reduce domestic employment, without giving domestic firms much of a leg up. One should also remember that an appreciation of the dollar reduces U.S. export competitiveness in much the same way as higher tariffs placed by foreign governments on U.S.-made goods. The real trade-weighted dollar has appreciated by 20% since mid-2014 (Chart 2). While this obviously has been unpleasant for U.S. exporters, it has not pushed the economy into recession. Neither will retaliatory foreign tariffs. Chart 1Trump's Supporters Are Not ##br##Free Trade Enthusiasts Chart 2The Dollar Has Been ##br##Appreciating Since Mid-2014 Why The Consensus On Trade Is Misleading The view expressed above is far outside the consensus and clashes strongly with the large number of studies arguing that the implementation of Trump's trade agenda would have grave consequences for the U.S. economy. Let me first enumerate the ways these studies fall short on strictly economic grounds, and then discuss why they may still ring true if one takes a broader perspective. As far as the pure economics are concerned, these studies all suffer from some combination of the following deficiencies: They assume that foreign producers can fully or almost fully pass on the cost of U.S. tariffs to their customers. In reality, the evidence suggests that foreign producers will absorb about half of the increase in tariffs through lower profit margins. In other words, the imposition of a 20% tariff would only raise U.S. import prices by around 10%. Granted, retaliatory tariffs would squeeze the profit margins of U.S. exporters. However, this effect would be mitigated by the fact that the U.S. runs large bilateral trade deficits with China and Mexico (Chart 3), as well as the fact that foreign producers have less pricing power in the relatively large U.S. market than American producers have abroad. On net, this implies that higher trade barriers could actually make the U.S. better off by shifting the terms of trade in its favor. Chart 3The U.S. Runs Large Bilateral Trade Deficits With China And Mexico These studies treat tariffs like regular old taxes. To the extent that tariffs are taxes whose burden is partly borne by domestic consumers, their imposition has a dampening effect on activity. However, to model the impact of higher tariffs simply as a tightening of fiscal policy implicitly assumes that any tariff revenue will be used to pay down debt, rather than being used to finance tax cuts and spending increases. Given that Trump is touting a program of fiscal stimulus, that is not a sensible assumption. Moreover, unlike, say, a sales tax hike, higher tariffs divert demand towards domestically-produced goods. This tends to boost employment. These studies overstate the adverse effect of tariffs on domestic investment. More than half of global trade consists of capital equipment and intermediate goods (Chart 4). To the extent that higher tariffs raise the cost of production, this can lower investment. Moreover, trade barriers tend to increase economic inefficiencies. This can lead to slower productivity growth, causing firms to reduce capital spending. In practice, however, neither effect is particularly significant. As we discussed two weeks ago, the negative impact of trade barriers on productivity growth is generally overstated, especially for large economies like the United States.1 Chart 5 shows that productivity growth was actually faster in the three decades following the Second World War than in the hyper-globalization era that began in the early 1980s. Chart 4Intermediate And Capital Goods ##br##Make Up Over Half Of Global Trade Chart 5Rising Trade Has Not ##br##Boosted Productivity Growth While the price of capital goods does influence investment spending, for the most part, firms tend to base their investment decisions on the expected demand for their products. Since the U.S. runs a trade deficit, an equal percentage-point decline in both exports and imports would increase final demand through the familiar Y=C+I+G+X-M identity. This should lead to higher investment. Moreover, even if higher trade barriers leave final demand unaffected, there are reasons to think that investment would still rise. Think about a closed economy where most households decide all of a sudden that they prefer strawberry ice cream over vanilla ice cream. Let us assume, just for the sake of argument, that shifting production from vanilla to strawberry ice cream is very difficult and requires a lot of new investment. What do you expect would happen to overall investment in this economy? The answer is that it would likely rise, as companies scramble to build out new strawberry ice cream-making capacity. Now extend the analogy to trade. If the U.S. slaps tariffs on manufacturing imports, this will lead to a wave of new domestic investment in industries that benefit from tariff protection. This is bad news for companies that must incur the cost of relocating production back onshore, but it is good news for American workers who can now find gainful employment. The Bigger Picture Our guess is that in purely economic terms, the U.S. would not suffer much if the Trump administration were to forge ahead with its protectionist trade agenda, and could actually benefit if America's trading partners felt restrained in how they could retaliate. Yet, focusing only on the economics misses the bigger picture. Trade agreements are also about politics - they help form the geopolitical glue that holds the global community together. As we noted two weeks ago, the real reason the 1930 Smoot-Hawley Tariff Act was so disastrous was not because it contributed to the Great Depression, but because it led to a breakdown of international relations among democratic governments at a time when fascism was on the rise.2 Donald Trump's threat to pull out of trade deals and unilaterally impose tariffs on countries that he feels are engaging in unfair trade practices is likely to accelerate the shift to a multipolar geopolitical order where competing countries strive to carve out their own spheres of influence. As Chart 6 shows, such geopolitical orders have often contributed to the breakdown of globalization, and at times, have even led to military conflict. Chart 6AIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand Chart 6BIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand The fact that rising protectionism could benefit the U.S. at the expense of other countries is bound to stoke anger abroad. China, the focus of much of Trump's rhetoric, is especially vulnerable. Trump has threatened to declare the country a "currency manipulator," even though it meets only one of the three criteria for such a designation as set out by the Treasury Department.3 Other countries should not breathe a sigh of relief, however. There is a certain logic about protectionism that makes it difficult to hike tariffs on just one or two countries. For example, if the U.S. raises tariffs on China, some of the existing demand for Chinese goods will be diverted to countries such as Korea or Vietnam, rather than back to the U.S. This creates an incentive to raise tariffs on those countries as well. It is easy to see how the whole global trading system can break down under such circumstances. Investment Conclusions Donald Trump's threat of across-the-border tariffs of 35% on Mexican goods and 45% on Chinese goods will likely turn out to be a negotiating ploy. That said, some increase in trade barriers seems inevitable. These need not even be explicit barriers. Trump's success in browbeating Carrier into keeping its plant open in Indiana is an example of things to come. Corporate America does a lot of business with the government, and the subtle threat of cancelled government contracts will make any CEO take notice. Good news for Main Street perhaps, but definitely bad news for Wall Street. For now, investors are focusing on the positive elements of Trump's agenda. That may change soon. Yes, increased infrastructure spending and corporate tax cuts are both bullish for stocks. However, effective U.S. corporate tax rates are already quite low thanks to numerous loopholes. Thus, any cuts to statutory rates may not boost S&P 500 profits by as much as investors are hoping (Chart 7). And while more infrastructure investment is welcome, there simply are not enough "shovel ready" projects around. Chart 7U.S. Effective Corporate Tax Rate Is Already Quite Low Moreover, Trump's plan to finance infrastructure spending through private-public partnerships greatly narrows the universe of possible projects. The U.S. Society Of Civil Engineers estimates that most of the "infrastructure gap" consists of deferred maintenance (i.e., potholes to fix, bridges to repair).4 It is difficult to get investors interested in such work, which is why it is typically financed directly through government budgets. Meanwhile, financial conditions have tightened via a stronger dollar and higher bond yields (Chart 8). Historically, such a tightening has been bearish for stocks (Table 1). We are tactically cautious on a three-month horizon, and are positioned for this by being short the NASDAQ 100 futures. Our guess is that global equities will correct by about 5%-to-10% from current levels, setting the stage for positive returns down the road. U.S. high-yield spreads, which are near post-crisis lows, are also likely to widen (Chart 9). Chart 8U.S. Financial Conditions Have Eased Chart 9U.S. High-Yield Spreads Likely To Widen Table 1Stocks Tend To Suffer When Bond Yields Spike A correction in risk assets could temporarily knock down Treasury yields. Nevertheless, the long-term path for global bond yields is to the upside. The three key features of Trump's platform - fiscal stimulus, tighter immigration controls, and trade protectionism - are all inflationary. Only JGB yields are likely to stay put for the foreseeable future due to the BOJ's well-timed decision to peg the 10-year yield at zero. As bond yields elsewhere rise, the yen will come under further downward pressure. We see USD/JPY reaching 125 in 12 months' time. Chart 10Global Growth Is Accelerating A weaker yen should boost Japanese stocks, at least in local-currency terms. European equities will also benefit from a somewhat cheaper euro and firming global growth (Chart 10). Steeper yield curves are helping to boost European bank shares, despite ongoing concerns about the health of the Italian financial sector. As we have discussed in the past, systemic risks around the Italian banks are overstated.5 With that in mind, we are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. The recent rally in commodity markets and the uptick in global activity indicators are welcome developments for emerging markets. Still, it will be hard for EM equities to muster a sustainable rally as long as the dollar remains in an uptrend and protectionist sentiment is on the rise. For now, a modest underweight in EM stocks is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1,2 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 3 The U.S. Treasury is allowed to define a country as a currency manipulator if: i) it runs a large trade surplus with the U.S.; ii) it has an excessively large current account surplus with the rest of the world; and iii) it is engaging in direct foreign exchange intervention in order to weaken its currency. While the first criterion arguably holds, the other two do not, given that China's overall current account surplus currently stands at 2.4% of GDP and recent currency intervention has been designed to prevent the yuan from depreciating more than it would have otherwise. 4 Please see "Failure to Act: Closing the Infrastructure Investment Gap for America's Economic Future," American Society of Civil Engineers (2016). 5 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. 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-8 * 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
Highlights Global Duration: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. 2017 Global Yield Curve Expectations: The recent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in Japan (at the long end), flatter in the U.K., Canada, Australia and New Zealand. U.K. Inflation Protection: Take profits on our recommended U.K. inflation trades (overweight inflation-linked bonds and CPI swaps), in response to the recent stability of the Pound and signs that the Bank of England is shifting in a more hawkish direction. Feature Time To Tactically Take Profits On Short Duration Positions Investors have been reminded over the past few months that boring old bonds, just like equities, can generate painful losses when prices disconnect from fundamentals. Back on July 19, we moved to a below-benchmark stance on overall portfolio duration, as we noted that government bonds across the developed markets had reached an overbought extreme despite improving trends in global growth and inflation (Chart of the Week).1 Bonds have sold off smartly since, with benchmark 10-year government yields in the U.S., U.K., Germany and Japan rising +88bps, +60bps, +36bps, +27bps respectively. The popular market narrative is that the latest leg of the bond selloff is a direct result of Donald Trump winning the White House. This raised investor awareness to the bond-bearish implications of a protectionist U.S. president looking to provide a fiscal kick to an economy already at full employment. The reality, however, is that global bond yields troughed a full four months before the U.S. elections on the back of a better global growth picture. It is quite possible that the latest bump in yields would have happened even if Trump did not win the election. Rising industrial commodity prices, happening in the face of a strengthening U.S. dollar that typically dampens prices, also suggest that bond yields have been responding more to faster realized growth and inflation and less to future expected fiscal stimulus (Chart 2). Chart of the WeekGlobal Bonds##br## Are Oversold Chart 2Stronger Growth Has ##br## Pushed Yields Higher Looking ahead, if the global economy evolves as we expect, with growth continuing to look relatively robust and inflation continuing to grind higher, then yields have even more upside in 2017. However, bonds now appear deeply oversold amid highly bearish sentiment. U.S. Treasury yields, in particular, have overshot the fair value estimates from our models (Chart 3). Also, this week's ECB meeting is unlikely to provide any bearish surprises for bond investors, as the ECB will likely extend the current QE program (at the current pace of buying) until at least next September. This should act to cap the recent widening of global bond term premia (Chart 4) and prevent a "Fifth Tantrum" from unfolding in global bond markets, as we discussed last week.2 Therefore, we are taking profits today on our bearish bond call and moving back to a tactical at-benchmark portfolio duration stance. However, we still expect yields to rise over the next year to levels beyond current forward rates.3 Thus, we would look to reinstate a below-benchmark duration posture if the 10-year U.S. Treasury yield were to fall to the 2-2.2% range. We will also look for signs of oversold momentum fading and a reduction in short positioning in U.S. Treasuries before re-establishing a below-benchmark duration tilt (Chart 5). The next leg of pressure on global bond yields should come from the U.S., given our optimistic view on U.S. growth and inflation for next year (see below). Chart 3UST Yields Are##br## A Bit Too High Chart 4A Big Adjustment In##br## Term Premia & Expectations Chart 5Taking Profits On##br## Our Bearish Bond Call Bottom Line: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. Some Initial Thoughts On Developed Market Yield Curves In 2017 With only a handful of trading days remaining in 2016, it is time to peer ahead to how markets could perform in the New Year. We will be publishing our full 2017 Outlook report on December 20th, but this week we are presenting some preliminary ideas on how government bond yield curves could evolve over the course of next year. United States - Eventual Bear Steepening In Excess Of The Forwards We see U.S. growth accelerating to a 2.8% pace next year, an above-potential pace that is stronger than current consensus forecasts.4 Combined with a steady grind higher in realized inflation (both headline and core), this will generate a nominal growth outcome over 5% in 2017. This will help push the 10-year U.S. Treasury yield to the 2.8-3.0% area by the end of 2017 as the Fed will likely continue to raise rates but not as fast as nominal growth will accelerate (i.e. will remain accommodative). This move will be led by rising inflation expectations, which we see rising to a level consistent with the Fed's inflation target.5 This will put steepening pressure on the U.S. Treasury curve, at a pace that will easily exceed the flattening currently priced into the forwards (Chart 6, top panel). We see the potential for curve steepening pressure to come both from growth, which will push up longer-dated real yields and steepen the "real" yield curve, and from inflation, with a tight labor market putting upward pressure on wage and price inflation even with a stronger U.S. dollar (Chart 7). Chart 6A Steeper UST Curve,##br## Led By Rising Real Yields Chart 7Will UST Yields Pause##br## After A Rate Hike Next Week? For now, however, we are keeping a "neutral" stance on U.S. yield curve exposure until we see signs that oversold conditions in the Treasury market have corrected. One final point: the Treasury market likely moved too quickly in recent weeks to discount a fiscal ease under the new Trump administration. However, any impetus to growth from the government sector, coming at a time when the U.S. economy is running near full employment, will be another structural factor putting steepening pressure on the yield curve in the next year through more Treasury issuance and stronger inflation pressures. Core Euro Area - Very Modest Steepening In Line With The Forwards As we discussed in a recent Weekly Report, the ECB will most likely continue with its current bond-buying program, with no tapering of the size of the purchases, until at least September 2017.6 European inflation remains too low relative to the ECB's target (Chart 8) and the central bank will be wary about reducing monetary stimulus anytime soon. The overriding presence of ECB buying will act to limit the upside in longer-dated European bond yields, even in an environment where U.S. Treasury yields rise over the course of 2017. The core European government bond yield curves (Germany, France) will likely still see some modest steepening pressure, led by upward pressure on real yields, as global growth continues to improve. Combined with the lagged impact of the weakening Euro and the rise in commodity prices, there should be some mild additional steepening pressure coming from inflation expectations, as well. The forward curves are currently pricing in a very modest steepening over the next year, and we do not see a case for the curve to steepen much beyond the forwards (Chart 9). We continue to favor core Europe as a recommended overweight in our global Developed Market bond allocation. Favoring the longer-end of the curve (10 years and longer) in Germany and France - the higher yielding parts of these low-yielding bond markets - makes the most sense against the backdrop of subdued Euro Area inflation. Chart 8No Threat To Global Bonds##br## From The ECB This Week Chart 9ECB QE Will Limit##br## Any Curve Moves In Europe Japan - Expect Long-End Steepening, Even With Bank Of Japan Curve Targeting The Japanese yield curve is now fairly straightforward to predict, with the Bank of Japan (BoJ) now explicitly targeting the level of JGB yields. The BoJ has committed to keep the 10yr JGB yield at 0% until Japanese inflation expectations overshoot the 2% BoJ target. With inflation expectations currently sitting just above 0%, that goal is now far from being realized. We see very little movement in the 2-10 year part of the JGB curve next year, but we expect the curve beyond 10 years to be more influenced by trends in global bond yields, with the BoJ providing no guidance on the desired level of longer-dated JGB yields. Given our views on a potential bear-steepening of the U.S. Treasury curve in 2017, we expect that the 10/30 JGB curve will also steepen (Chart 10). Focusing Japanese bond exposure on the 10-year point makes the most sense in this environment, although at a yield of 0% the return prospects are hardly inviting. U.K. - Steepening Will Turn To Flattening The Bank of England (BoE) took out a very large insurance policy on the U.K. economy by cutting interest rates and re-starting quantitative easing (QE) after the shocking Brexit vote. This has appeared to work, as U.K. economic growth has been surprisingly strong in the months since the June referendum. But the ramifications of the BoE's aggressive easing was a massive depreciation of the Pound and a subsequent rise in U.K. inflation (Chart 11). Chart 10BoJ Is Not Worrying About##br## The Long End For JGBs Chart 11The Post-Brexit ##br## Adjustment Is Nearly Complete This has set up a situation where the Gilt market is behaving much like the U.S. Treasury market did after the Fed introduced its own QE programs between 2008 & 2012. The result was as rise in nominal bond yields led by rising inflation expectations and stronger economic growth, both of which were a function of a weaker currency. In the case of the U.K. now, the rise in inflation has been strong enough to force the BoE to back off its promise to deliver an additional rate cut before the end of 2016. The BoE will likely not extend the latest QE program beyond the March 2017 expiry, as well. There is even a chance that the BoE could be forced to hike rates sometime in the first half of 2017. Against this backdrop where the BoE has to play a bit of monetary catchup to rising nominal growth, the Gilt curve is likely to see some flattening pressure after the recent steepening. With the forwards pricing in no change in the slope of the curve next year (Chart 12), curve flattening positions that limit exposure to the front-end of the Gilt curve could offer opportunities in 2017 after global bond yields consolidate the recent rise in yields. While we believe it is too early to reposition our Gilt curve allocation this week, we are taking profits on our recommended U.K. inflation protection trades given the recent stability of the Pound and growing evidence that the Bank of England is turning more hawkish (Chart 13). Specifically, we are closing our Overlay Trade favoring index-linked Gilts versus nominals at a profit of +59bps. We also advise closing our "Brexit hedge" trade suggested in June before the referendum, which was a long position in U.K. CPI swaps versus U.S. equivalents. Chart 12Nearing The End Of ##br## Gilt Curve Steepening? Chart 13Take Profit On U.K.##br## Inflation Protection Trades Canada - The Steepening Is Over A modest steepening of the Canadian government bond yield curve in 2017 is currently priced into the forwards. We think even this small move is unlikely to be realized. The short-end of the yield curve should stay well-anchored around current levels. Probabilities extracted from the Canadian Overnight Index Swap (OIS) curve currently show a 4% market-implied chance of a rate cut, and 40% odds of a rate hike, by December 6th 2017. Of the two, the probability of a rate hike looks too high. The Bank of Canada (BoC) has rarely increased policy rates when our BCA Canadian Central Bank Monitor was in "easy money required" territory (Chart 14). More likely, the Bank of Canada will stay on hold throughout 2017 due to a lack of inflationary pressures. The Canadian unemployment rate remains far higher than the full employment level, while a wide gap has developed between the growth rates of core CPI and weekly earnings; low wage inflation usually drags core CPI inflation lower. Already, the Canadian CPI less the most volatile components - one of the core inflation measures monitored by the BoC - has rolled over. In the longer part of the curve, the weakening economic cycle will keep yields well contained. While the rebound in energy prices seen this year is a positive for the beaten-up Alberta economy, even higher prices will be needed for Canadian energy producers to rekindle investments in that sector given the high cost of oil extraction in Western Canada. Without a meaningful recovery in Alberta, the Canadian economy will be unable to expand at an above-trend pace; growth will be slower than the general consensus forecast of 2.0% in 2017.7 To profit from that view, we are opening a new butterfly spread trade on the Canadian curve: going long the 2-year/10-year barbell versus a short position in the 5-year bullet. This trade should generate positive excess returns if the 2-year/10-year slope of the Canadian curve flattens, as we expect (Chart 15). Chart 14Canadian Short Rates##br## To Remain Well-Anchored Chart 15Go Long A Canadian 2/10 ##br## Barbell Vs. The 5yr Bullet Australia - Flattening Phase Ahead A small flattening of the Australian yield curve over the next 12 months is currently priced into the forwards. This expectation seems reasonable to us, but the bulk of the flattening should come from the short end where yields will drift higher over the course of the year. Australian inflation prospects are improving, with the Melbourne Institute Inflation Gauge having stabilized of late. As the negative impact of imported goods price deflation recedes going forward, domestic inflation should rise. In addition, our model is calling for core CPI inflation to grind higher in 2017 (Chart 16). Chart 16Australian Inflation Is Bottoming... Chart 17...Even As Australian Growth Is Starting To Cool Because of this, the Reserve Bank of Australia (RBA) will progressively become less dovish and greater odds of a rate hike will be priced into the yield curve. This is already starting to happen, on the margin; since October, the probability of a rate cut by December 5th, 2017 has decreased substantially, from 65% to 5%. As we have been pointing out over the past several months, the Australian economy has been humming along. China's policy reflation seen earlier in 2016 had a direct positive impact on Australian export demand, while a rising terms of trade fueled by higher base metals prices has provided a boost to domestic income. However, the upward pressure on yields from accelerating domestic growth has become milder of late. Employment growth, motor vehicle sales and aggregate private sector credit growth are now all trending to the downside (Chart 17). This might be an indication that the boom from the first half of this year is starting to dissipate. This tames, to some extent, our optimism over the Australian economy. If economic activity continues to slow modestly, corporate bond supply, i.e. demand for credit and liquidity, should ease. In turn, this should also alleviate the recent upside pressure on the longer part of the Australian government bond yield curve. Chart 18The NZ Curve Will Follow##br## The Forwards In 2017 In sum, on a 3-6 month horizon, the short end of the Aussie curve could edge higher as the market prices in a less dovish RBA that will need to begin worrying about rising inflation once again. While at the same time, longer-term bond yields might have seen their highs given some cooling of economic growth. We already have a recommended position on the Australian curve to benefit from these trends, as we are short the 4-year government bond bullet versus a long position in the 2-year/6-year barbell. This trade was initiated earlier this year, has generated +13bps of profits so far, and remains valid.8 As an exit strategy, we will re-evaluate this trade if high-frequency cyclical Australian data disappoint further or the current expansion of Australia's terms of trade starts to reverse. New Zealand - Following The Forwards The New Zealand forward yield curve is currently pricing a 12bps flattening over the next 12 months, with the 2-year/10-year slope expected to move from 107bps to 95bps (Chart 18). This move seems reasonable to us. As we discussed in a recent report, inflation will re-surface in New Zealand in 2017.9 The upside surprise will be due to those factors: Narrowing global output gaps that will bring about a more inflationary global backdrop. A boost from China, most notably through higher producer prices. A weakening of the Kiwi dollar in response to a more hawkish Fed. A stronger dairy sector, which should help New Zealand's exports and reflate domestic wages. A potential reversal of migration inflows, which should shrink the supply of workers and tighten the labor market, boosting wage growth and pressuring price inflation higher. If this view materializes, the Reserve Bank of New Zealand (RBNZ) will become more hawkish. This should push short term yields higher and flatten the New Zealand government bond yield curve. Like everywhere else, the New Zealand yield curve has steepened over the last month as global bond markets have priced in faster growth and the potential impact of Trump-ian fiscal stimulus in the U.S. As this external impact dissipates in the next few months, the main factor driving the shape of the New Zealand curve will swing back to expectations of future RBNZ policy. Bottom Line: The recent consistent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in the long end in Japan; flatter in the U.K., Canada, Australia and New Zealand. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 3 The current 1-year forward rate for the benchmark 10-year U.S. Treasury is 2.67% 4 Please see BCA Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen", dated October 14, 2016, available at gis.bcaresearch.com 5 The Fed targets headline PCE inflation, while inflation compensation in U.S. TIPS is priced off headline CPI inflation. The historical gap between the two measures is about 40bps, thus a level of breakeven inflation in TIPS that is consistent with the Fed's 2% inflation target is 2.4% (2% PCE inflation + 0.4%). 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com 7 Both the Bank of Canada and the median economist surveyed by Bloomberg forecast 2.0% real GDP growth in 2017. For further details, please http://www.bankofcanada.ca/2016/10/mpr-2016-10-19/ 8 Please see BCA Global Fixed Income Strategy Weekly Report, "Five Yield Curve Trades For The Rest Of The Year", dated May 24, 2016, available at gfis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Weekly Report, "A Post-Trump Update Of Our Overlay Trades", dated November 22, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1More Upside From Inflation We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights An Italian referendum 'no' is not really revolting. Some people are voting no for no change to the current constitution's vital checks and balances. Lean against any knee-jerk widening of the Italian sovereign yield spread versus France that followed a no vote. Lean against any knee-jerk rally in Italian banks that followed a yes vote. A 50bps spike in the JPM Global Government Bond Yield in just 3 months is normally a bad omen for risk-asset performance. Retain a cautious stance to risk-assets on a 3-month horizon. Feature After shock victories for Brexit and Donald Trump at the polls, a 'no' vote in Italy's December 4 referendum on constitutional reform would be the next worrying sign of a growing grassroots revolt against the establishment. Or would it? An Italian 'No' Is Not Really Revolting The votes for Brexit or Donald Trump were clearly votes for change. At first glance, an Italian no would also look like a revolt, with the potential to trigger political uncertainty and instability in the euro area's third largest economy. Chart of the WeekItalian Banks Are Tracking Japanese 'Zombie' Banks The truth is more nuanced. Clearly, some Italians are voting no to reject Prime Minister Renzi. But others - including former Prime Minister Mario Monti - are voting no for no change. These voters want to leave in place the current constitution's vital checks and balances. If Italians vote yes to constitutional reform, the upper house of parliament - the Senate - would be relegated to an advisory chamber. Meanwhile, an already approved new electoral law for the lower house of parliament - the Chamber of Deputies - hands an automatic 55 percent majority of seats to the largest party. Some people fear that this combination would amount to excessive executive power. So they are voting no to mitigate the danger. Granted, a no vote might also force Renzi to resign, but this would not necessarily trigger new elections. President Sergio Mattarella would likely explore options for a new government - perhaps a technocratic government - which the parties in the current governing coalition have a strong incentive to support until the next elections are due in 2018. Even if there were early elections, it is improbable that they would result in a government led by the populist 5 Star Movement. If 5 Star was the largest party, it would hold a 55 percent majority of seats in the lower house, but only 30 percent in the upper house, in proportion to its popular vote share (Chart I-2). Therefore, it could not form a government. Under the current constitution, the government needs the support of both houses. The irony is that a yes vote - by giving the executive excessive powers - would make it more likely for a populist party like 5 Star to form a government in 2018 or beyond. Still, even this might prove a tall order. Italy's constitutional court is reviewing the electoral law change that gives 55 percent of lower house seats to the largest party. The court will likely demand more proportionality, making it hard for any one party to win an outright majority. This means more coalition governments, which 5 Star rejects. Hence, an Italian no will not be the equivalent of the Brexit vote or U.S. election of Donald Trump. Fears that it will unleash a dangerous phase of populism and political instability in Italy are overblown. Yet in the last three months, the Italian sovereign yield spread has widened sharply versus France (Chart I-3). Note also that the 65-day fractal dimension of the Italy versus France sovereign bond performance is close to its technical limit, indicating excessive pessimistic groupthink. Chart I-2The 5 Star Movement Could Not Form A ##br##Government Under The Current Constitution Chart I-3Italy's Political Risk Premium Has ##br##Increased, But Is It Justified? If December 4 brings a no vote in the Italian referendum combined with the election of a far-right President of Austria - whose role is largely ceremonial - the knee-jerk market response might still be fright. In which case, a further widening in the Italy/France yield spread would be a tactical entry opportunity, given that political risk is overstated. Fixing Italian Banks Needs A 'Deep-V' Or A 'Long-L' The real question in Italy is not about an imminent populist backlash. The real question is what does the cure for Italy's banking malaise look like? The answer is either a 'deep-V', meaning a banking crisis forces a quick workout; or a 'long-L', meaning no banking crisis but a very long struggle back to normal health. As an investor, neither seems particularly appealing. Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the housing-related credit booms in Ireland, Spain, the U.K. and the U.S. did eventually cause housing busts and full-blown financial crises - requiring urgent government-led and central bank-led bailouts. Today, Italian banks' non-performing loans (NPLs) account for 18% of gross lending, and NPLs net of provisions equal 85% of equity capital. A few years ago, Irish banks looked even worse. Irish NPLs peaked at 25% of gross lending in 2013 and net NPLs peaked at 100% of equity capital. Following government bailouts Irish banks have recovered well (Chart I-4 and Chart I-5). Likewise, the Spanish government created a 'bad bank' in 2012 to offload bank NPLs. Subsequently, Spanish banks' NPLs as a share of gross lending has almost halved. Chart I-4Ireland Looked Worse Than Italy##br## For NPLs As A Share Of Loans Chart I-5Ireland Looked Worse Than Italy ##br##For NPLs As A Share Of Capital Compared to Ireland and Spain, Italy's avoidance of outright crisis (thus far) appears a blessing. Unfortunately, it is now a curse. In waiting so long, Italy cannot follow Ireland, Spain, the U.K. and the U.S. in their escapes from their banking woes. The EU Bank Recovery and Resolution Directive (BRRD), which came into full force on January 1 2016, has blocked the bailout escape route. The BRRD does allow state intervention in a banking crisis. But the overarching aim is to protect banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors. Therefore, in a banking crisis "other parts may be allowed to fail in the normal way... after shares in full... then evenly on holders of subordinated bonds and then evenly on senior bondholders." For bank investors, this would constitute the 'deep-V' cure: likely intense pain up-front albeit with much better long-term prospects thereafter. Alternatively, without a crisis, the process to recognise and expunge NPLs would be largely up to the private sector and markets. But a long chain of events from the repossession of assets under bankruptcy law, to valuation, to full divestment from the banks' balance sheets could take years. Indeed, the Chart of the Week shows a striking parallel between Italian bank profits and Japan's 'zombie' bank profits, if we lag the Japanese experience by 17 years. Japan perfectly illustrates this alternative 'long-L' cure: no outright crisis, just a long and seemingly never-ending struggle back to normal health. Either way, absent any further information, we would lean against any knee-jerk rally in Italian banks that followed a yes vote on December 4. What Happens When Bond Yields Spike? Turning to the broader financial markets, a bigger concern is the impact that sharply higher bond yields will have on growth and/or on risk-asset valuations. Higher long-term borrowing costs depress credit growth as captured in the credit impulse (Chart I-6 and Chart I-7). A depressed credit impulse then almost always drags down subsequent GDP growth. The recent spike in U.S. 15-year and 30-year mortgage rates has already caused mortgage refinancing applications to plunge by 40% since July (Chart I-8). Chart I-6Higher Bond Yields Depress##br## Credit Growth In Europe... Chart I-7...And In ##br##The U.S. Chart I-8Mortgage Applications##br## Have Plunged Prior to the current incidence, a 50bps rise in the JPM Global Government Bond Yield in just 3 months has occurred only eight times this century (Chart I-9). Table I-1 lists those eight occasions and the subsequent 3-month performance of the equity market. On three out of the eight occasions, the equity market rose modestly, but on the other five it fell. Chart I-9The Bond Yield Has Spiked Table I-1What Happens When Bond Yields Spike? But perhaps the most interesting finding is that on all eight occasions, the equity market's subsequent 3-month performance consistently deteriorated, on average by -7%, compared to the preceding 3-month performance. For reference, today's preceding 3-month performance is just 0.7%. Given this evidence, it is prudent to retain a cautious stance to risk-assets on a 3-month horizon. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The Italy versus France sovereign bond underperformance indicates excessive pessimistic groupthink. However, in this instance we would wait until after Italy's December 4 referendum on constitutional reform before initiating the countertrend trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * 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
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights U.S. bond yields and the U.S. dollar will rise further. Consistently, EM currencies and local bonds will continue selling off. There is meaningful downside in EM exchange rates. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KOR, MYR, IDR, TRY, ZAR, BRL, COP and CLP. Within domestic bond portfolios, overweight low-beta defensive markets as well as Russia and Mexico. Our underweights are Turkey, South Africa, Malaysia and Indonesia. The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy. Feature Emerging market (EM) risk assets will likely continue to be driven by both rising U.S. bond yields and a strong U.S. dollar over the next two months or so. Beyond the next couple of months, the focus of the markets will likely switch to China: renewed weakness in growth and possible instability in its financial markets, with negative implications for China plays globally and for commodities prices in particular. The combination of these two negative forces will lead to a considerable drop in EM currencies in the next six months or so. In turn, EM currency depreciation will trigger broad liquidation of EM risk assets. BCA's Emerging Markets Strategy service believes that EM risk assets will continue to sell off in absolute terms, and underperform their DM/U.S. peers. EM Local Bonds The total return (including carry) index of JPM GBI-EM1 local currency bonds in U.S. dollar terms has rolled over at a critical resistance level (Chart I-1). The total return index of EM local bonds has also relapsed relative to the total return of 5-year U.S. Treasurys, failing to break above its long-term moving average (Chart I-1, bottom panel). Consistently, domestic bond yields have troughed at important technical levels in several key countries such as Brazil, Turkey, Colombia, Russia, South Africa and Malaysia (Chart I-2A and Chart I-2B). Chart I-1EM Local Bonds' Total ##br##Return In US$: Failed Breakout Chart I-2AHave EM Domestic ##br##Bond Yields Bottomed? Chart I-2BHave EM Domestic ##br##Bond Yields Bottomed? In short, EM local bonds are exhibiting negative technical dynamics that corroborate our downbeat fundamental analysis. Consequently, we believe the total return JPM GBI-EM index in U.S. dollar terms will drop to new lows for the following reasons: Currency swings are responsible for most of the fluctuations in EM local bond total returns. As we have elaborated numerous times and re-assert in this report, the outlook for EM exchange rates remains gloomy. Foreign holdings of EM local currency bonds are substantial (Table I-1). Even though there have been improvements in a few countries, current account and fiscal deficits generally remain wide in the majority of developing nations (Chart I-3A and Chart I-3B). In other words, a number of EM economies are still at risk from a slowdown in foreign funding. Table I-1Foreign Holdings Of EM Local Bonds Chart I-3ACurrent Accounts And Fiscal Deficits Chart I-3BCurrent Accounts And Fiscal Deficits Chart I-4U.S. And EM Local Yields Notably, the bar for exchange rate depreciation is very low in EM economies with current account deficits. It takes only a reduction in net capital and financial inflows - i.e., net outflows are not necessary - for these countries' currencies to depreciate significantly. As net foreign funding diminishes, exchange rates of countries with current account deficits should weaken and interest rates should rise in order to compress domestic demand, which in turn would equalize the current account deficit to net inflows in capital and financial accounts. Finally, the spread of EM local bonds (the yield for GBI-EM global diversified index) over duration-matched (5-year) U.S. Treasury yields has not risen much (Chart I-4). Heightened risks in EM currencies warrant higher local bond yield spreads over U.S. Treasurys. Bottom Line: Absolute return investors should stay away from EM local currency bonds. U.S. Bond Yields And The Dollar: More Upside We expect U.S./DM bond yields to keep rising as re-pricing in global fixed income markets continues. The decline in DM bond yields in recent years until the latest selloff was enormous, and some sort of mean reversion should not come as a surprise. Our bias is that this selloff will likely continue until sometime in January, when U.S. President-elect Donald Trump takes office. This riot in the bond market could, in retrospect, resemble a typical "sell the rumor, buy the news" pattern. In other words, by the time President-elect Trump takes office, a lot of bad news will already be priced into the U.S. bond markets, creating a buying opportunity. In our July 13 Weekly Report,2 we argued that: "In the U.S., the combination of a healthy labor market and a heavily overbought fixed-income market have created the backdrop for a material rise in U.S. interest rate expectations/bond yields. As U.S. rate expectations climb, the U.S. dollar should gain support. This in turn will create headwinds for EM currencies and other EM risk assets." Then, we reiterated this view in our July 27 Weekly Report: "Nowadays, there is little talk in the investment community about a bond bubble and the potential for much higher bond yields. Indeed, "lower for longer" has begun to dominate the investor lexicon. This is a sign that many G7 bond bears have likely capitulated. Investor consensus on bonds has become quite bullish, and many investors are long duration. When many bears capitulate, the odds of a market selloff inevitably rise. "Importantly, the increase in G7 bond yields might not be gradual as many expect because of the following: with yields at such low levels, bonds' duration is high and price changes become very sensitive to changes in yield... Such (large) price changes (drops) would amount to large losses for bond investors, and forced selling could intensify. As a result, the unwinding of long positions could be abrupt and volatile." For now, odds are that U.S. bond yields will rise further. Given global bond funds have seen massive inflows in recent years, the latest drop in prices of various bonds has been substantial and will likely trigger withdrawals and redemptions from bond funds, prompting forced selling. This is true for all types of bond portfolios, including DM government and corporates, EM credit (U.S. dollar bonds) and EM local currency bonds. U.S. bond yields are still low, even from the perspective of the past several years, and the market-implied terminal fed funds rate is still 80 basis points below the median projection of the Federal Open Market Committee's longer-run rate (Chart I-5). Given that U.S. interest rate expectations are not high at all, they will rise further (Chart I-6) as the uptrend in U.S. wages persists - driven by an already reasonably tight labor market (Chart I-7). Chart I-5U.S. Interest Rate Expectations Are Still Low Chart I-6U.S. Wage Growth Is Accelerating Chart I-7More Upside In U.S. Treasurys Yields Finally, the U.S. dollar will continue to be buoyed by rising U.S. interest rate expectations. Our composite momentum indicator for the broad trade-weighted U.S. dollar has bounced off the zero line (Chart I-8). This constitutes a strong technical confirmation of the durable bullish market trend in the dollar. Bottom Line: Odds are that the rise in U.S. bond yields is not over. As U.S. bond yields rise further, EM currencies and bonds will sell off. Long-Term EM Currency Trends We have several observations on the long-term performance of EM currencies and financial markets: In the long run, there is no guarantee that the majority of EM currencies will appreciate in real terms (adjusted for inflation differentials). In fact, even countries such as Korea and Taiwan - which have been very successful in their economic development and have tremendously grown their income per capita - have seen their real (inflation-adjusted) exchange rates depreciate over the past several decades (Chart I-9). The case for long-term appreciation in real terms is even weaker for exchange rates in countries that exhibit chronically high inflation rates and/or current account deficits. This has been true for many non-Asian EM currencies (Chart I-10). Chart I-8The U.S. Dollar Is ##br##In A Genuine Bull Market Chart I-9Long-Term Currency ##br##Downtrends In Korea And Taiwan Chart I-10EM Currency Trends: ##br##A Long-Term Perspective Importantly, most losses to foreign investors in EM financial markets often occur via currency depreciation. This is even truer in the current bear market downtrend. The JPM ELMI+ currency total return index (including cost of carry) seems to be about to break down (Chart I-11). In EM ex-China, the real effective exchange rate is still elevated (Chart I-12). Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Chart I-11EM Currency Return With Cost ##br##Of Carry Versus U.S. Dollar Chart I-12Weak Productivity Means ##br##Further Currency Depreciation To limit the upside in domestic interest rates - both in bond yields and interbank rates - many developing nations' central banks will inject more local currency liquidity into their respective systems.3 This might help cap local interest rates, but is bearish for their currencies. The Turkish central bank has been among the most aggressive in this disguised money printing, and not surprisingly the value of its currency has collapsed (Chart I-13). There is no long-term history for EM currencies, as before 1998 most developing nations' exchange rates were pegged. Yet when one examines EM equities' relative performance against the S&P 500, it emerges that there is no single EM bourse that has outperformed U.S. stocks on a consistent basis in the very long run. Chart I-14A and Chart I-14B demonstrate that among 11 EM equity markets that have a long-term history, none have outperformed the S&P 500 over the past 30-35 years. Chart I-13Turkey's Central Bank Has Been ##br##Pumping Local Currency Into The System Chart I-14AEM Equities Versus The S&P 500: ##br##A Long-Term Perspective Chart I-14BEM Equities Versus The S&P 500: ##br##A Long-Term Perspective This goes to reveal that the starting point of underdevelopment and the mark "emerging" does not guarantee consistent outperformance even in the long run. In fact, EM's relative performance against the U.S. has followed multi-year cycles, and we believe the current bear market and underperformance is not yet over. While EM underperformance is long in duration, economic and financial adjustments remain incomplete. DM QE programs and China's still-growing credit bubble have delayed the adjustment. As a rule, the longer a financial or economic imbalance/excess lingers, the more protracted the adjustment will be. Bottom Line: EM exchange rates will continue depreciating. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP. For a complete list of our open currency and fixed-income trades please refer to page 18. Country Allocation For EM Local Bond Portfolios Chart I-15 demonstrates the relationship between developing countries' foreign funding requirements and their real (inflation-adjusted) local bond yields. The foreign funding requirement is calculated as the sum of the current account deficit and foreign debt service obligations over the next 12 months. We use inflation-linked (real) bond yields for markets where they are available. In other cases, we subtract the headline inflation rate from nominal bond yields to derive the real one. Chart I-15Real Bond Yields And Foreign Funding Requirements: A Cross Country Comparison The higher the foreign funding requirement, the higher the real yield must be to attract foreign capital, all else equal. On this diagram, the value pockets are Brazil (its real yield of 6.3% offers the best value by far), Indonesia, Russia and India. Domestic real yields in these countries are relatively high compared to their foreign funding requirements, which is a proxy for exchange rate risk. In contrast, Turkey, Chile, Colombia, Hungary and Malaysia have low real yields relative to their large foreign funding requirements. However, there are other factors that are shaping local yields. For example, Brazilian real yields look very attractive on this matrix because the latter does not account for public debt dynamics. The fiscal dynamics in Brazil are dreadful.4 On the contrary, Chilean local bonds appear expensive, but the country's fiscal outlook is very healthy. After considering all factors that affect local bond yields as well as incorporating the currency outlook, we recommend the following allocations: Overweight Korea, Thailand, Poland, Hungary, the Czech Republic, Russia and Mexico (Chart I-16). For investors who can invest in Chinese, Taiwanese and Indian local bonds, we also recommend overweighting these markets within an EM domestic bond portfolio. Underweight Turkish, South African, Malaysian and Indonesian local currency bonds (Chart I-17). We will publish our analysis on Indonesia soon. Stay neutral on domestic bonds' total return in U.S. dollar terms in Brazil (with a negative bias because of the considerable currency risk), Chile and Colombia (Chart I-18). Chart I-16Our Recommended ##br##Overweights In Local Bonds Chart I-17Our Recommended ##br##Underweights In Local Bonds Chart I-18Local Bonds ##br##Warranting A Neutral Allocation A Word On China's Commodities Frenzy Speculative fever is running high in Chinese commodities exchanges. Frenetic commodities trading in China has seen prices skyrocket of late (Chart I-19). Prices often rise a limit during a day. We have the following observations: This stampede into commodities is a reflection of rotating bubbles in China. Mania forces rotated from property to stocks, then to corporate bonds, and then back to housing, again. It seems to be shifting into commodities now. While the mainland's industrial sector and real demand for commodities have registered gradual improvement in recent months, the sharp spike in commodities prices largely reflects speculative activity much more than real demand. In fact, net imports of base metals have been flat for the past six years (zero growth in six years), and all swings have most likely been related to inventory cycles (Chart I-20). Chart I-19The Spike In Commodities ##br##Prices Trading In China Chart I-20China: Net Import Of Base Metals Like any speculative frenzy, this is momentum-driven and will one day crash. Timing the reversal is impossible. A lot depends on policymakers' willingness to confront this speculative bubble and investor psychology. Notably, onshore corporate bond yields and swap rates have recently begun rising. As in DM bonds, the rise in yields from very low levels is causing large price drops. As and if yields rise further, losses in corporate bonds will become considerable and investors (especially ones managing retail investors' money) will head for the exits, triggering liquidation. This, along with the eventual unraveling of commodities speculation poses substantial potential risk to global, or at least EM, financial markets. Bottom Line: The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy that will end badly. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments. 2 Please see Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016. 3 Please see "EM: Is The Liquidity Upturn Genuine And Sustainable?" Parts I & II, dated November 25, 2015 and December 2, 2015, respectively. 4 Please refer to the Emerging Markets Strategy Special Report, "Brazil: The Honeymoon Is Over," dated August 3, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations