Global
Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Dear Client, There will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on September 4th. Best regards, Ryan Swift Highlights Global Growth Divergences: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. But history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporates: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wages will exacerbate the problem, much like in the late 1990s. Municipal Bonds: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Feature "It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." - Alan Greenspan, September 19981 Fed Chairman Alan Greenspan uttered the above sentence in early September 1998. Russia had just defaulted on its government debt and a few weeks later the heavily-exposed hedge fund Long-Term Capital Management would require a bail-out, kicking off a period of turmoil in U.S. financial markets. The Federal Reserve responded by cutting interest rates by 75 basis points between September 30th and November 4th, despite a domestic labor market that Chairman Greenspan described as "unusually tight." We recall this tumultuous period because a divergence between strong U.S. and weak non-U.S. growth is once again putting upward pressure on the U.S. dollar, leading to pain in emerging markets. So far it is the Turkish lira bearing the brunt of the sell-off, but the lesson from the late 1990s is that other EMs, and eventually the U.S., are also vulnerable. A joint Special Report, published last week, from our Foreign Exchange Strategy and Geopolitical Strategy services provides a blow-by-blow account of the late 1990s period, with implications for today's currency markets.2 In this week's report, we focus on what divergences between strong U.S. growth and weak non-U.S. growth mean for U.S. bond portfolios. A History Of False Starts The divergence between strong U.S. and weak non-U.S. growth is illustrated in Chart 1. The shaded regions in the chart correspond to periods when the Global (ex. U.S) leading economic indicator (LEI) is contracting while the U.S. LEI continues to rise. There have been 10 such episodes since 1966. In the four instances that occurred prior to 1993, the U.S. economy remained insulated from flagging growth in the rest of the world. That is, the U.S. LEI continued to expand and the Global (ex. U.S.) LEI eventually recovered into positive territory. However, since 1993, every time the Global (ex. U.S) LEI has dipped below zero the U.S. LEI has eventually followed. In other words, prior to 1993 the U.S. economy acted very much like an oasis of prosperity. But global events have become much more important since then. Chairman Greenspan's claim was correct in 1998 and remains relevant today. Case Study: 1997 Two of the post-1993 growth divergence episodes are particularly relevant for bond investors today. The first occurred in 1997 (Chart 2). The Fed tried to kick off a rate hike cycle in March 1997, but the combination of a Fed rate hike and weak foreign growth led to a surge in the dollar. Eventually, the strong dollar dragged our Fed Monitor below zero and the Fed was forced to abandon rate hikes until June 1999. In the interim, the Fed's dovish turn caused the dollar to halt its uptrend (Chart 2, panel 3). Treasury yields collapsed and then recovered (Chart 2, panel 4). Credit spreads moved in line with the exchange rate (Chart 2, bottom panel), widening alongside a stronger dollar in 1997/98, and then leveling off as the Fed eased policy and the dollar moved sideways. The end result of the 1997 episode is that Treasury yields took a round trip, falling as the Fed backed away from its rate hike path, then rising again once rate hikes resumed. Credit spreads, however, never fully recovered their 1997 tights. Case Study: 2015 More recently, growth divergences flared again in 2015 (Chart 3). This time, our Fed Monitor was already recommending rate cuts in late-2015, but the Fed pressed on and delivered the first rate hike of the cycle that December. Once again, the combination of a hawkish Fed and weak foreign growth put upward pressure on the dollar (Chart 3, panel 3), and the Fed was forced to pause its rate hike cycle. Chart 1The Weight Of The World Chart 2False Start 1997 Chart 3False Start 2015 Much like in 1997, Treasury yields declined as the Fed went on hold and then started to rise again as rate hikes resumed (Chart 3, panel 4). Also like 1997, credit spreads widened alongside the strengthening dollar, though this time they actually managed to tighten back to new lows when the Fed went on hold and the upward pressure on the dollar abated in 2016/17 (Chart 3, bottom panel). Implications For The Present Day Chart 4Inflation Is Much Closer To Target What lessons can we take away from these two episodes? The first is that if growth divergences continue to worsen and the dollar continues to appreciate, it will eventually cause our Fed Monitor to dip below zero and the Fed will likely pause its rate hike cycle. Such a dovish pause will lead to a decline in Treasury yields and a flattening-off, or even depreciation, of the dollar. However, we also know from history that any decline in Treasury yields is likely to prove fleeting. Once dovish Fed action takes the shine off the dollar, foreign economic growth will improve and the Fed will soon be able to resume rate hikes. This was the case in both 1997 and 2015. There is even reason to believe that any pause in Fed rate hikes could be particularly short-lived this time around. Inflation is already closing-in on the Fed's target and there is some evidence that long-dated inflation expectations have become stickier. Long-maturity TIPS breakeven inflation rates have not fallen much in recent weeks, even as weakening foreign growth has dragged down commodity prices (Chart 4). As for credit spreads, history shows that they are likely to widen as global growth divergences deepen and the dollar appreciates. Then, any pause in Fed rate hikes will improve credit's outlook for a time. Once again, because relatively strong inflation will limit the length of time that the Fed can pause lifting rates, we think any period of spread tightening that coincides with more dovish Fed policy will be short-lived. We also see similarities with the 1997 episode in terms of the outlook for corporate defaults. Such similarities bode ill for credit spreads, as is discussed in the next section. Bottom Line: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. However, history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporate Defaults: Look To The Late 1990s Considering the two case studies presented above, the reason corporate bonds performed worse in 1997 compared to 2015 is that in 1997 corporate leverage and defaults started to creep higher and did not peak until the 2001 recession. In contrast, corporate leverage flattened-off and defaults fell once the Fed paused its rate hike cycle in 2016 (Chart 5). Chart 5Corporate Defaults: The Late 1990s Roadmap Looking closer, the bottom panel of Chart 5 shows that once profit growth fell below the rate of debt growth in 1997 it continued to trend down. In 2015/16, profit growth was again dragged lower by the strong dollar, but it quickly rebounded once the Fed turned dovish. In our view, if global growth divergences continue to worsen and the dollar continues to strengthen, the next increase in corporate leverage will probably look more like 1997. To see why, we consider the two reasons why profit growth decelerated in 1997. The first is the obvious reason that the strong dollar started to weigh on corporate revenues. The growth in business sales moderated and the PMI dipped below 50 (Chart 6). Today, we have not yet seen enough dollar strength to weigh on business sales or the manufacturing PMI, which is still hovering around 60 (Chart 6, bottom panel). But this will change as the emerging market turmoil spreads and eventually impacts the U.S. business sector. The second reason why the 1997 corporate default episode is the most comparable to the present day is that much like in 1997, but unlike in 2015, the labor market is extremely tight and wages are starting to accelerate (Chart 7). The growth in unit labor costs started to outpace the growth in corporate selling prices in 1997, and this caused our Profit Margin Proxy to fall (Chart 7, panel 2). At present, our Profit Margin Proxy is very close to the zero line, but with a sub-4% unemployment rate further downside is likely. Finally, much like in 1997, small businesses are increasingly citing labor quality as a more important problem than lack of sales (Chart 7, bottom panel). The difference between the rankings of these two problems has done a good job tracking profit growth historically. This indicator is currently at levels that are much more reminiscent of the late 1990s. Chart 6Dollar Strength Drags Down Revenue Chart 7Wages Will Weigh On Profits Bottom Line: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wage growth will exacerbate the problem, much like in the late 1990s. Take Shelter In Municipal Bonds Chart 8Munis As A Safe Haven Another implication of the divergence in growth between the U.S. and the rest of the world is that fixed income sectors that are more exposed to the domestic U.S. economy and less exposed to foreign growth and the exchange rate should fare better. In this regard, municipal bonds are an obvious candidate. While state & local government net borrowing has flattened off at a relatively high level during the past few quarters, state governments have recently re-committed to austerity (Chart 8). Data from the National Association of State Budget Officers show that states enacted a net $9.9 billion increase in revenues in fiscal year 2018, with another $2.8 billion planned for fiscal year 2019. Historically, revenue raises of this magnitude have led to declines in net borrowing, which should ensure that municipal ratings upgrades continue to outpace downgrades for the time being (Chart 8, bottom panel). But there's an even better reason for investors to favor municipal bonds. Quite simply, yields remain attractive compared to the riskier corporate alternatives, particularly at longer maturities. The top section of Table 1 shows relevant statistics for the 5-year, 10-year and 20-year tax-exempt Bloomberg Barclays Municipal bond indexes, along with the closest comparable indexes from the investment grade corporate sector. We observe that a 5-year Aa-rated municipal bond carries a yield of 2.18% versus a yield of 3.26% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 33% should be indifferent between the two bonds. Any investor exposed to an effective tax rate above 33% should favor the municipal bond, even before considering the differences in risk between the two sectors. Moving further out the curve, the breakeven tax rate falls to 24% at the 10-year maturity point and to either 13% or 21% at the 20-year maturity point, depending on whether you use Aa-rated or A-rated corporate debt as the relevant comparable. We also find that High-Yield municipal debt looks attractive compared to the corporate alternative. The Bloomberg Barclays High-Yield Muni Index (excluding Puerto Rico) trades at a breakeven tax rate of 18% relative to a Ba-rated corporate bond, and 33% relative to a B-rated corporate bond. Even the taxable municipal space is attractive. The bottom section of Table 1 shows that the average yield on the 1-5 year taxable municipal bond index is slightly higher than that of the closest comparable corporate bond index. The same goes for the 5-10 year taxable muni index. Table 1A Comparison Of Municipal And Corporate Bond Yields Finally, drawing on work we presented in a recent Special Report, we provide total return forecasts for different municipal bond indexes along with the comparable corporate sector indexes (Table 2).3 We show results for three different effective tax rates, depending on how many rate hikes you expect from the Fed during the next 12 months and whether you expect Municipal / Treasury yield ratios to remain flat, widen to their post-2016 highs, or tighten to their post-2016 lows. Table 2Municipal Bonds Total Return Forecasts Vs. Corporate Sector Comparables For example, in an environment where the Fed delivers four rate hikes during the next 12 months and Municipal / Treasury yield ratios remain flat, an investor with a 24% effective tax rate can expect a total return of 2.81% from the 10-year Municipal bond index. If we adjust returns using the top marginal tax rate of 37% the expected total return rises to 3.52%. In the same scenario, where corporate spreads also remain flat, investors can expect a total return of 2.86% from a corporate bond with similar duration and credit rating. Bottom Line: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/speeches/1998/19980904.htm 2 Please see Foreign Exchange Strategy / Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The 2018 dollar rally is principally the consequence of the slowdown in global industrial activity and global trade, itself a reverberation of China's efforts to de-lever and reform its economy. For China, reforms and deleveraging are here to stay, suggesting the dollar rally and EM rout are not over. However, in response to U.S. President Donald Trump's trade battling, China is stimulating its economy in order to limit its own downside. The chances of miscalculation on the part of Beijing are high. This raises the risk that investors begin pricing in a much more aggressive reflation campaign. Such a reflation campaign would cause a correction in the dollar and give more lift to the current rebound in EM assets. In order to track this risk and hedge it, investors should monitor and buy a portfolio made up of iron ore, Brazilian equities, AUD/JPY, Swedish industrial equities and EM high-yield bonds. Feature Many assign the strength in the dollar this year to the Federal Reserve increasing interest rates at a faster pace than other advanced economies. While monetary divergences seems like both a historically plausible and intuitive explanation, it rings hallow. The Fed was hiking rates at a much faster pace than the rest of the world last year, yet the dollar had a horrendous 2017, falling 10%. In our view, the trend in global growth has had a much more important role in explaining the dollar's performance. When global trade and global industrial production is strong, this normally leads to a period of weakness in the dollar. The opposite also holds true; soft global growth is associated with a strong dollar (Chart I-1). Behind this relationship lies the low-beta nature of the U.S. economy. Since its economy is not as levered to exports and manufacturing as the rest of the world is, the U.S. benefits less when global growth is improving (Chart I-2). As a result, when global growth is on the up and up, investors can upgrade the economic and inflation outlook for Europe faster than they can for the U.S. In the process, long-term rate expectations rise faster in Europe than the U.S., attracting money into Europe and out of the U.S. The process can be replicated across most economies outside the U.S. This hurts the dollar. Chart I-1The Dollar Likes ##br##Poor Global Growth Chart I-2The U.S. Economy Is Less##br## Sensitive To Global Growth To understand the outlook for the greenback, it is crucial to understand the outlook for global economic activity. Many commentators have pinned the blame of slowing global growth on the back of rising protectionism. The problem with this thesis is that global growth began slowing before investors took protectionist risks seriously. Instead, in our view, the key culprit behind the global growth slowdown has been policy tightening in China. Therein lies the issue. China has slowed, and President Xi Jinping is signaling that his administration will continue to push ahead with deleveraging the Chinese economy. This should imply weaker industrial growth in China and in the rest of the world and therefore a stronger dollar. However, with protectionism on the rise, the Chinese authorities are announcing virtually every day new measures to soften the blow to the Chinese economy. This stimulus could support global growth, and hurt the dollar, at least tactically. Our Geopolitical Strategy team believes the desire to reform and de-lever the Chinese economy will ultimately prevail, and thus so will a stronger dollar. However, the growing list of stimulus measures implemented in China supports our thesis, articulated last month, that a counter-trend correction in the dollar will first materialize before the greenback rally begins anew.1 As such, we continue to recommend investors hedge their long USD bets, and that traders with a short-term horizon take advantage of a portfolio we propose in this report. China Drives Growth And Returns Differentials We have long argued that China has a disproportionate role in determining what happens to growth outside the U.S. To some extent, this argument is almost tautological: at PPP exchange rates, China produces 24% of global GDP outside the U.S. But there is more than meets the eye to this argument. China is the world largest investor, with Chinese capital investment accounting for 26% of global capital formation, or 6.5% of the world's GDP. This means that the growth rate of Chinese investment has a large direct impact on global industrial good exports around the world. There is a second-round effect as well: China is also the largest consumer of industrial commodities globally. This implies that China is the marginal consumer and thus the price-setter of many natural resources. However, commodity producers account for a large share of global capex, 10.5% from 2004 to 2017. Thus, through its impact on commodity prices, China also impacts the demand for global industrial and capital goods via the capex needs of commodity exports. This large footprint can result in some counterintuitive relationships. For example, why is it that Chinese economic variables explain so well the gyrations of French exports to Germany, its largest export market (Chart I-3)? This conundrum is explained by the fact that German economic activity is deeply affected by Chinese growth. Since German growth is the key determinant of German imports, it follows that Chinese activity plays a large role in driving French exports. This pattern gets repeated across Europe, as Germany is the leading trading partner of most European nations. China does not have the same impact on the U.S. economy (Chart I-4) as total U.S. exports only represent 13% of GDP and exports to China, a measly 0.6% of GDP. Manufacturing also only represents 11% of U.S. GDP, again limiting the impact of secondary benefits of Chinese growth on the U.S. economy. Chart I-3What Drives French Exports To Germany: China Chart I-4Chinese Growth Has Little Impact On U.S. Growth Thanks to this difference, we can spot one very useful relationship that we have highlighted to our clients for more than a year: when the Chinese authorities stimulate their economy, European growth picks up sharply vis-a-vis the U.S. (Chart I-5).2 In this optic, the growth outperformance of Europe in 2017 made perfect sense; it was a consequence of China's aggressive push to reflate after 2015. 2018 is the mirror image of 2017; European growth is underperforming as a result of China's efforts to limit growth. This also means that wherever China goes going forward, so will the growth gap between the euro area and the U.S. Chart I-5AIf European Growth Beats That ##br##Of The U.S., Thank China (I) Chart I-5BIf European Growth Beats That ##br##Of The U.S., Thank China (II) Since Chinese growth affects the distribution of economic activity around the world, China affects the distribution of rates of returns around the world as well. Nowhere is the influence of China more evident than in the spread between U.S. and global bond yields. If we accept that Chinese growth exerts a limited influence on the domestically driven U.S. economy but exerts a large impact on the rest of the world, Chinese economic fluctuations should have an implication on the relative interest rate outlook between the U.S. and the rest of the world. This is indeed the case. As Chart I-6 shows, when the growth of China's nominal manufacturing GDP slows relative to the U.S., U.S. bond yields rise relative to yields in other major economies. Since money flows where it is best treated, the impact of China on relative rates of returns and interest rates around the world should be felt in the dollar. This is also the case. When Chinese nominal manufacturing GDP growth accelerates, the dollar tends to suffer as money leaves the U.S. and finds its way into Europe, Australia, Canada, EM and so forth to take advantage of rising marginal rates of returns relative to the U.S. (Chart I-7). Chart I-6Treasurys Vs. The World Equals U.S. Nominal GDP ##br##Vs. Chinese Manufacturing Chart I-7The DXY Moves In Opposition##br## To Chinese Manufacturing Bottom Line: The U.S. economy does not benefit as much from rising Chinese economic activity as the rest of the world does. This means that U.S. relative rates of return fall when China booms and rise when China busts. This also implies that China is just as important as the Fed in determining the trend in the dollar: A strong China is associated with a weak dollar, and vice-versa. Chinese Deleveraging Is Dollar Bullish, But... Despite its large debt load, China does not have a debt problem per se. With a savings rate of 46% of GDP and a limited stock of foreign currency debt, China does not exhibit the necessary conditions to end up like Argentina or Asian economies in the late 1990s. Instead, China's problem remains misallocated capital. China's debt load has increased by USD23.6 trillion since 2008. This is a lot of capital to invest in a short time span. Poor investments have been made, resulting in excess capacity in many industries, and most crucially a collapse in total factor productivity (Chart I-8). This decline in productivity represents a real threat to China's long-term viability, especially as China's labor force is set to begin declining and its leadership wants to avoid the middle-income trap that has plagued so many EM economies in the past. In order to avoid this trap, China's long-term growth is dependent on a sustained effort to de-lever and reform. Our Geopolitical Strategy team is adamant that Xi Jinping remains committed to this agenda. Long-term growth is his priority - a luxury now made possible by his "long-term" mandate.3 The impact of reforms is most evident through the evolution of credit growth. As Chart I-9 illustrates, total social financing has been slowing. The bottom panel of Chart I-9 also illustrates that the collapse in the Chinese credit impulse has followed the implosion of bond issuance by small financial institutions. This essentially tells us that the ongoing administrative and regulatory tightening of the shadow banking system is bearing fruit: Financial institutions are curtailing their issuance of exotic instruments, which is hurting overall credit growth - even if old-school bank loans are proving resilient. Chart I-8China: Labor Force And Total Factor ##br##Productivity The Need For Reforms Chart I-9Deleveraging In ##br##Action Since credit growth is so fundamental to generating investment and supporting the country's manufacturing sector, this implies that Chinese manufacturing activity has ample downside. As a result, we would anticipate that China will continue to be a drag on the rest of the world for many more quarters. This implies that the U.S. dollar has upside, and that EM plays as well as commodity currencies are especially vulnerable. While this view seems clear, and most investors now well understand the investment ramifications of Chinese reforms and deleveraging, sand has been thrown in the wheels of this narrative. As a result, the uptrend in the dollar and the downtrend in EM assets may take a pause. Bottom Line: China needs to de-lever further and reform its economy. Without this growth strategy, the country will be stuck in the dreaded middle-income trap, as its productivity has collapsed. Since deleveraging in China means less investment and slower manufacturing sector growth, this also means that the dollar should benefit, and EM-related assets should suffer, but... ... Stimulus Is A Potent Narrative The sand in the wheels of the dollar-bullish scenario created by Chinese reforms and their retardant effect on Chinese industrial growth is, paradoxically, President Trump's trade war with China. China decided to implement reforms last year because stronger growth out of the euro area and the U.S., its two largest export markets, should have buffeted its economy against some of the deflationary consequences of deleveraging. However, if President Trump tries to limit the growth of Chinese exports to the U.S., this create yet another shock that China does not need. This makes it much more difficult for China to deal with the deflationary consequences of its own reform efforts. As a result, not only have the Chinese authorities let the yuan depreciate by 8% since April, the fastest pace of decline since the 1994 devaluation, they have also begun announcing a slew of stimulus measures over the course of recent weeks: The People's Bank of China has engaged in RMB502 billion of liquidity injections, especially through its medium-term lending facility; Three reserve requirement ratio cuts have been implemented, freeing up RMB2.8 trillion of liquidity; Local governments have been allowed to increase net new bond issuance this year by up to RMB2.2 trillion; The issuance of special purpose bonds by local governments has been accelerated; Banks with high credit quality standards can reduce provisioning for NPLs; Individual income tax cuts have been announced; And modifications to the macro prudential assessment's structural component have been announced, which will free up new lending by commercial banks. These stimulus measures are not designed to cause growth to accelerate. In fact, as Jonathan LaBerge argues in our China Investment Strategy service, they pale in comparison to the total amount of stimulus implemented in 2015, especially as back then, RMB5 trillion in credit had also been injected into the economy.4 However, a problem remains for investors. Even if these measures are far from enough to cause Chinese growth to re-accelerate, they can easily foment the following narrative: Chinese policymakers are trying to calibrate their policy response in order to support growth. However, they are human beings, and do not know a priori how much stimulus will be needed to support growth without causing credit growth to actually surge. As a result, they will push stimulus into the system until the economy responds. But once the economy responds, it will be too late, and the lagged impact of stimulus will cause a sharp rebound in credit and capex. The opacity of Chinese policy and data raises the chance that this simplification will take over the investment community. Such reversion to simplicity in the face of ambiguity and intractable complexity is a well-documented phenomenon in sociology.5 Even if this narrative is mistaken and not based in actual reality, investors who view Chinese fundamentals as bullish to the dollar and bearish to EM and commodity plays need to be ready for this eventuality. We are reluctant to close our long dollar trade based on a narrative alone. Instead, we have purchased protection by selling USD/CAD as a hedge. However, we also offer investors a mean to observe if this narrative does take hold of the market, by tracking a portfolio of assets very sensitive to the outlook for Chinese growth, and thus very sensitive to Chinese reflation. These assets are: Chinese Iron ore prices, expressed in USD; Swedish industrial equities, expressed in USD; Brazilian equities, expressed in USD; AUD/JPY; And EM high-yield bond denominated in USD. Chart I-10 illustrates the performance of a portfolio composed of these assets, weighted in such a way that they contribute equally to the variance of the portfolio. As the chart illustrates, not only is this portfolio massively oversold, suggesting there is plenty of negatives already priced into China-linked assets, it has begun to rebound. Chart I-11 illustrates that the Chinese Li-Keqiang Index of industrial activity leads this index.6 The recent rebound in the LKI already supports the idea that this portfolio could have upside in the coming months. Moreover, if investors do extrapolate that additional stimulus measures are likely to come out of Beijing, this will support even greater upside to this portfolio. Chart I-10An Index To Monitor... Chart I-11...Or A Vehicle To Bet On Impactful Stimulus As a result, we would go one step beyond suggesting this portfolio as a tracker for Chinese reflation. Investors should buy it. If you are bearish on the Chinese growth outlook, buying this portfolio offers protection against countertrend moves that would hurt long-dollar and short-EM bets (our preferred strategy). If, however, you are bullish on Chinese reflation, this portfolio should prove a very rewarding vehicle to implement such views. Bottom Line: Chinese reforms are a tailwind for the dollar. However, they are now confronted with the reality of trade wars, which is causing the Chinese authorities to stimulate their economy to put a floor under growth. Nevertheless, this exercise is fraught with calibration errors - a risk that market participants can easily uncover. This raises the probability that a countertrend correction in the dollar will emerge. To monitor this risk, we recommend investors track a portfolio of assets heavily influenced by Chinese growth: Iron ore, Swedish industrial equities, Brazilian stocks, AUD/JPY, and EM high-yield bonds. Moreover, if one is already long the dollar, this portfolio can also be used as a hedge against the risk created by investors pricing in large-scale Chinese stimulus. If one disagrees with our view that reforms will ultimately take primacy on stimulus, one can also use this portfolio as a high-octane way to play Chinese reflation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Reports, titled "Time To Pause And Breathe", dated July 6, 2018 and "That Sinking Feeling" dated July 13, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Special Reports, titled "China: Looking Beyond The Party Congress" dated July 19, 2017, and "China: Party Congress Ends...So What?" dated November 1, 2017, both available at gps.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator" dated July 26, 2018, available at cis.bcaresearch.com 5 Smelser, Neil J. "The Rational and the Ambivalent in the Social Sciences: 1997 Presidential Address." American Sociological Review, vol. 63, no. 1, Feb. 1998, pp. 1-16. 6 The Li-Keqiang index is based on railways freight traffic, bank credit, and electricity output. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Gross Domestic Product growth underperformed expectations slightly, coming in at 4.1%, reflecting a large decline in inventories. In fact, real final sales were strong, growing at a 5.1%. The ISM manufacturing survey also came in slightly below expectations, softening to 58.1 from 60.2 in July. It is still indicative of above-trend growth. However, the Chicago PMI surprised positively, coming in at 65.5. This measure also increased form last month's reading. While the DXY was able to rally this week thanks to growing tensions between the U.S. and China, we expect the dollar to have short-term downside, as the temporary stimulus by the Chinese authorities should give an ephemeral boost to global growth, a development that would hurt the dollar. That being said, impact should ultimately prove to be transient, and the dollar. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The yearly growth of GDP underperformed expectations, coming in at 2.1%. This also represented a decrease relative to the previous quarter. However, both core and headline inflation surprised to the upside, coming in at 2.1% and 1.1% respectively. Moreover, the European Commission's economic sentiment indicator also outperformed to the upside, coming in at 112.1. However, this measure decreased from last month's reading. EUR/USD was relatively flat for most of the week until a wave of risk aversion prompted by worries of a Sino-U.S. trade war took hold of the market, lifting the dollar in the process. In a mirror image to our dollar view, we expect the euro to have upside in the next couple of months, but resume its downward trajectory by the end of the year. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Retail sales yearly growth beat expectations, coming in at 1.5%. Moreover, the jobs-to-applicants ratio also surprised to the upside, coming in at 1.62. However, the unemployment rate surprised negatively, coming in at 2.4% and increasing from last month's number. However, this reflected an increase in the participation rate. Finally, the consumer confidence index also underperformed expectations, coming in at 43.5. USD/JPY has risen by roughly 0.5% this week after it became clear that the BoJ only marginally adjusted its policy, in a way that only confirmed its highly dovish bias. Interestingly, while the spike in JGB yields has reverberated across global bond markets, it has not been able to provide a boost for the yen. While we expect the trade-weighted yen to appreciate by the end of this year as Chinese policymakers still want China to de-lever, a period of interim weakness is possible as the PBoC tries to buffet the Chinese economy against the impact of U.S. protectionism. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The Nationwide house price index yearly growth rate outperformed expectations, coming in at 2.5%. This measure also increased relatively to last month's number. Moreover, PMI construction also surprised to the upside, coming in at 55.8, and increasing from last month's reading. However, Markit manufacturing PMI underperformed expectations, coming in at 54. GBP/USD was relatively flat this week, but ultimately experienced a large fall following the hike by the BoE as investors began to worry that the "old lady" is making a policy error that will need to be reversed. Overall, we remain negative on cable, as the ability for the BoE to continue on their hiking campaign will be limited given the current political turmoil in Britain. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Building permit yearly growth outperformed expectations, coming in at 1.6%. Moreover, producer prices also surprised positively, coming in at 1.5%. However this measure decreased compared to last month's reading. Finally, the RBA Commodity Index SDR yearly growth surprised to the downside, coming in at 7.6%. AUD/USD fell this week as market wrestle with the risk to global growth created by the China-U.S. trade war. Overall, we continue to be negative on the Aussie on a cyclical basis, as this currency is the most exposed in the G10 to a slowdown in the Chinese industrial sectors. That said, a bout of stimulus in China could provide some short-term upside to AUD. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Employment growth surprised to the upside, coming in at 0.5%. However, this measure slowed from last month's reading. Moreover, the participation rate outperformed expectations, coming in at 10.9% and increasing from last month's number. However, the unemployment rate underperformed expectations, coming in at 4.5% and increasing from last month's reading. NZD/USD experienced a large fall this week. We are negative on the NZD on a cyclical basis, as tightening by both China and the U.S. along with trade tensions will provide for a toxic cocktail for small open economies like New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Industrial production month-mon-month growth outperformed expectations, coming in at 0.5%. Moreover, Monthly GDP growth also surprised positively, coming in at an annualized rate of 0.5%. However, the Markit Manufacturing PMI underperformed expectations, coming in at 56.9. This measure also declined relative to last month's number. The CAD is the only currency that managed to appreciate against the USD this week, despite a rather pitiful performance for crude oil. This dynamics comforts in our tactical bullish stance on the loonie. In fact, this pair is our preferred vehicle to play the countertrend correction in the U.S. dollar. Meanwhile, on a cyclical basis we are positive on the Canadian dollar within the commodity complex. Not only do supply constraint within OPEC will help oil outperform base metals, but also, the BoC is the only central bank within this group that is currently lifting interest rates. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator underperformed expectations, coming in at 101.1, and declining relatively to last month's reading. However, retail sales yearly growth surprised to the upside, coming in at 0.3%. Finally, the SVME Purchasing Manager's Index also surprised positively, coming in at 61.9, and increasing from last month's number. EUR/CHF has been relatively flat this week. On a long term basis, we are bullish on this cross, as inflationary pressures are still very weak in Switzerland. Therefore, the SNB will maintain its ultra-dovish stance, hurting the franc in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied vigorously this week. While the generalized dollar strength has been key culprit behind the depreciation of the NOK, the fall in oil prices only added fuel to the fire. Overall, we expect this cross to go up by the end of the year, as the interaction of Chinese and U.S. policy will likely push up the USD and weigh on commodities. That being said, the NOK will probably outperform within the commodity space, given that it is cheap and that supply cuts by OPEC should help oil prices on a relative basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at 0.2%, and declining substantially, from 3.1% last month. However, the annual growth rate of GDP outperformed expectations, coming in at very strong 3.3%. This measure stayed flat relative to the first quarter. Finally, Manufacturing PMI came in at 57.4, increasing from last month's number. USD/SEK still rallied this week as the SEK is particularly sensitive to the outlook for global growth. We are positive on the Swedish Krona on a long-term basis, as Sweden is the country in the G10 where monetary policy is most misaligned with economic fundamentals. Thus, if the Sweden continues to show strength, the Riksbank will eventually have to respond. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Global QE has made bonds as risky as equities. Thereby, global QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge. The good news is that record high valuations of risk-assets are fully justified if global bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if global bond yields march much higher. The 'rule of 4' for equity/bond allocation: sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. Above 3.5 means a neutral stance in equities... ... Above 4 means it's time to go underweight equities and overweight bonds. Feature Chart of the WeekAt Higher Bond Yields, The Correlation With Equity Prices Has Flipped From Positive To Negative The end is nigh for QE. The ECB will exit its asset purchase program at the end of the year. In doing so, it will mark the end of an epoch which began in the aftermath of the global financial crisis, a ten year period in which at least one of the world's major central banks has been buying a defined quantity of assets every month (Chart I-2). Approaching the end of the epoch, it is fitting to ask: how did the global QE stimulant work, and what will be the withdrawal symptoms? Chart I-2The End Is Nigh For QE As far back as 2011, in a provocative report titled QE And Riots we predicted that: "QE... will exacerbate already extreme income inequality and the consequent social tensions that arise from it" Events in the subsequent seven years have fully vindicated our prediction. Simply put, QE has front-loaded asset returns which would ordinarily have accrued in the distant future to the here and now - in the form of sharply higher capital values. So if you were invested in the financial markets or most housing markets, congratulations, you have received a bonanza; if you weren't, bad luck, there's not much left for you (Chart I-3). Chart I-3Equities Are Now Priced To Generate A Measly Long-Term Return To understand why, we need to delve deeper into behavioural economics. QE: Why The Stimulant Was So Powerful Central banks admit that there is a lower bound for interest rates below which there would be an exodus of bank deposits. Once policy rates hit the lower bound, central banks can unleash a 'plan B': a commitment to keep policy rates at this lower bound for an extended period. QE is simply a powerful signalling tool for this commitment. As ECB Chief Economist Peter Praet explains: "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound)" The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too (Chart I-4). Chart I-4The Credible Commitment To Keep Policy Rates##br## Low Pulls Down Bond Yields Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent breakthroughs in behavioural economics. When bond yields approach the lower bound, the asymmetry in their future direction makes bonds very risky investments. The short-term potential for capital appreciation - nominal or real - vanishes, while the potential for vicious losses increases dramatically (Chart I-5). The technical term for this unattractive asymmetry is negative skew. Years of research in behavioural economics has led Nobel Laureate Professor Daniel Kahneman to conclude: negative skew is the measure that best encapsulates our perception of an investment's risk. Chart I-5Bonds Become Much Riskier ##br## At Low Bond Yields Professor Kahneman's work reveals a profound truth: global QE has made bonds as risky as equities (Chart I-6). The ramification is that equities and other risk-assets no longer need to lure investors with an excess return over bond returns. QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge.1 Chart I-6Global QE Has Made Bonds ##br##As Risky As Equities One counterargument we hear is that bonds offer investors a diversification benefit and, because of this, investors will still accept a lower return from bonds. But this argument is flawed. Just as bonds are a diversifier for equity investors, equities are a diversifier for bond investors. Indeed in recent years, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump's shock victory in 2016. So we could equally argue that equities require the lower return. In fact, with the same negative skew and symmetrical diversification properties, both assets must offer the same prospective return. The breakthroughs in behavioural economics provide some good news and some bad news. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if bond yields march much higher (Chart I-7). Chart I-7At Low Bond Yields The Required Return On ##br##Equities Plunges, So Equity Valuations Surge Financial Markets Dwarf The World Economy One common misunderstanding about QE is that it has been the bond purchasing itself that has held down bond yields. This seems a natural assumption because we connect the act of buying with higher prices (lower yields). Moreover, the $10 trillion of bonds that the 'big four' central banks have bought is not far short of the size of the euro area economy. But let's put this into context. The global bond market exceeds $100 trillion. Long-term bank loans amount to something similar. In this $217 trillion2 global fixed income market, $10 trillion of QE is peanuts. To reiterate, QE's impact came not from the $10 trillion of central bank purchases in itself, but from the signal that interest rates would remain at the lower bound for a long time, mathematically requiring bond yields to approach the lower bound too;3 and from the consequent equalization of negative skew on bonds and risk-assets, mathematically requiring an exponential rerating of all risk-asset valuations (Chart I-8). Chart I-8Equities Are Now Priced To Generate A Measly Long-Term Return Now note that the combination of equities and correlated risk-assets such as corporate and EM debt is worth around $160 trillion, and real estate is worth $220 trillion. World GDP is worth much less, around $80 trillion. So if returns from these richly valued risk-assets were reallocated from the here and now back to the distant future, through lower capital values today, there would be a very real risk that current spending could take a dive. Supporting this broad thesis, central bank measures of 'financial conditions easiness' are just tracking the level of the stock market (Chart I-9). Chart I-9Financial Conditions Are Just##br## Tracking The Stock Market The 'Rule Of 4' For Equities And Bonds On February 1 this year, we advised that the big threat to risk-asset valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." This advice has proved to be remarkably prescient. Whenever bond yields have been at the lower end of recent ranges, the correlation with equities has been positive, meaning equities have risen in tandem with bond yields. But whenever bond yields have moved to the upper end of recent ranges, the correlation has abruptly flipped to negative, meaning equities have fallen as bond yields have risen (Chart of the Week). While many strategists and commentators are fixated on the risks from trade wars and/or the global economy, our non-consensus call is that the biggest threat to risk-assets comes from rich valuations which will become dangerously unstable if bond yields march much higher. In this regard the bond yield that matters is the global bond yield. Previously we defined this in terms of the German 10-year bund yield and the U.S. 10-year T-bond yield. But today for completeness, we would like to add another important component: the Japanese 10-year government bond yield. The global bond yield is a weighted average of the three components. But for a useful rule of thumb, just sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. A sum above 3.5 means a neutral stance to equities. A sum above 4 - which broadly equates to the global yield rising above 2% - means it's time to go underweight equities and overweight bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017 3 In contrast, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! Fractal Trading Model* This week we note that the underperformance of emerging market versus developed market equities is technically stretched and ripe for at least a brief countertrend reversal. The 65-day trade is long EM versus DM with a profit target of 2.5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2018. The quant model lifted its U.S. allocation to be in line with the benchmark weight at the expense of Spain. No major changes in other country weights, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 59 bps in July, largely driven by Level 2 model which outperformed its benchmark by 146 bps. Level 1 model slightly unperformed its MSCI world benchmark by 5 bps in July. Since going live, the overall model has outperformed its benchmarks by 132 bps, driven by the Level 2 outperformance of 375 bps offset by the 2 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of July 31, 2018. Following the developments on the trade front and increasing worries of a growth slowdown, the model continues to maintain a defensive bias with an aggregate overweight of 5.8% relative to cyclical sectors. The relative tilts within cyclicals and defensives remain the same as the previous month. However, both discretionary and financials are going through unfavorable technical and momentum indicators. Energy remains the only resource based sector with an overweight, primarily driven by attractive long-term valuations. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com