Gov Sovereigns/Treasurys
Highlights Chart 1Too Close For Comfort The Fed is in the midst of tightening policy, but with inflation still below target it wants to ensure that overall policy settings remain accommodative. In the language of central bankers, the Fed wants to keep the real fed funds rate below its equilibrium level, the level that applies neither upward nor downward pressure to price growth. The equilibrium fed funds rate cannot be calculated with precision, but one popular estimate shows that policy settings are dangerously close to turning restrictive (Chart 1). While an announcement of balance sheet reduction is almost certain to occur next month, with the real fed funds rate so close to neutral, rate hikes are probably on hold until the gap widens. Higher inflation will widen the gap by causing the real fed funds rate to fall, and we are confident that core inflation will rise in the coming months (see page 11 for further details). This will permit the Fed to deliver more than the currently discounted 28 bps of rate increases during the next 12 months. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in July, bringing year-to-date excess returns up to 209 bps. The financial press is littered with stories highlighting extremely unattractive corporate bond valuations, but we think this storyline is exaggerated. In fact, the average spread on the Bloomberg Barclays corporate bond index is somewhat wider than is typically observed in the early stages of a Fed tightening cycle (Chart 2). We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 86 bps and traded in a range between 66 bps and 104 bps.1 Viewed in this context, the current spread of 102 bps looks somewhat cheap. That being said, corporate balance sheet health is worse than is typically seen during the early stages of a tightening cycle and this will limit spread compression from current levels. But all in all, excess returns to corporate bonds should be consistent with carry during the next 6-12 months, with higher inflation and tighter Fed policy being pre-conditions for material spread widening. In a recent report2 we showed that bank bonds (both senior and subordinate) still offer a spread advantage compared to other similarly risky sectors (Table 3). Banks also continue to make progress shoring up their balance sheets and the outlook for bank profits is starting to brighten. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in July, bringing year-to-date excess returns up to 448 bps. The index option-adjusted spread tightened 12 bps to end the month at 352 bps, 8 bps above the 2017 low. We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread almost in line with the average witnessed during other similar monetary environments. In contrast, the VIX index, which co-moves with junk spreads (Chart 3), is well below levels seen during the early stages of the prior two tightening cycles. The VIX currently sits at 10, and its historical range in similar monetary environments is between 11 and 17, with an average of 13.3 In this way, there would appear to be more room for investment grade corporate bond spreads to tighten than junk spreads, especially on a volatility-adjusted basis. Despite somewhat more stretched valuations than in investment grade, high-yield still offers reasonable compensation relative to expected defaults. At present, our estimated default-adjusted spread is 206 bps, only slightly below its historical average (panel 3). This is based on an expected default rate of 2.8% during the next 12 months and an expected recovery rate of 48% (bottom panel). MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to 4 bps. The conventional 30-year MBS yield declined 3 bps in July, as a small 1 bp increase in the rate component was offset by a 4 bps tightening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. Index OAS has been in a widening trend since bottoming at 15 bps last September (Chart 4). Since then, MBS have returned 43 bps less than duration-equivalent Treasury securities. The Bloomberg Barclays Aaa-rated Credit index has outperformed Treasuries by 71 bps during that same timeframe. The back-up in OAS reflects, in large part, the market pricing in the upcoming wind-down of the Fed's balance sheet, set to be announced next month. However, we think OAS still have further to widen to catch up with the rising trend in net issuance. According to Flow of Funds data, net MBS issuance totaled $83 billion in the first quarter. If that pace continues for the rest of the year, then 2017 will be the strongest year for MBS issuance since 2009. While higher mortgage rates since the end of 2016 present a drag, at least so far, home sales have not shown much weakness (bottom panel). This is unlike the 2013 taper tantrum when home sales fell sharply following the surge in rates. We are underweight MBS on the expectation that the housing market will remain resilient in the face of higher rates, allowing issuance to continue its uptrend. However, we are closely tracking the spread advantage in MBS compared to Aaa-rated credit which is finally starting to look attractive (panel 3). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to 149 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 81 bps and 112 bps, respectively. The low-beta Supranational and Domestic Agency sectors each outperformed by 5 bps. The Foreign Agency sector outperformed the duration-matched Treasury index by 56 bps. USD-denominated sovereign bonds have underperformed the Baa-rated U.S. Corporate index (their closest comparable in terms of risk) during the past three months even though the U.S. dollar has continued its trend lower (Chart 5). But despite this recent underperformance, the Sovereign index still does not offer a spread advantage over the Baa-rated U.S. Corporate index (panel 3). Further, while our Emerging Markets Strategy service still looks favorably upon the Mexican peso relative to other emerging market currencies, it does not expect the peso to continue its recent appreciation versus the U.S. dollar.4 We share this opinion, and expect the broad trade-weighted dollar to appreciate as U.S. growth rebounds in the back-half of the year.5 In our cross-sectional model, which adjusts spreads for credit rating and duration. Local Authorities and Foreign Agencies continue to look attractive compared to most U.S. corporate sectors. In contrast, the Sovereign and Supranational sectors appear expensive. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 38 basis points in July (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 186 bps year-to-date. The average Municipal / Treasury (M/T) yield ratio fell 2% in July, breaking below 85%. The average yield ratio remains extremely tight relative to its post-crisis trading range (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. Our early estimate, based on the recently released second quarter National Accounts data, shows that state & local government net borrowing probably moved higher in Q2 (panel 3), making the recent decline in yield ratios appear even more tenuous. The increase in net borrowing stems largely from a $21 billion drop in income tax revenues and a $20 billion decline in transfer receipts from the federal government. Income tax revenue should recover in the next two quarters,6 and we expect net borrowing will also start to decline. However, it is unlikely that net borrowing will fall by enough to justify current muni valuations. On July 6, the state House of Illinois overrode Governor Bruce Rauner's veto to finally pass a $36 billion budget. The move was sufficient for Moody's and S&P to both subsequently affirm the state's investment grade rating. The 10-year Illinois General Obligation bond yield declined 102 bps on the month, despite only a 1 bp drop in the 10-year Treasury yield. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull steepened in July. The 2/10 slope steepened 3 bps and the 5/30 slope steepened 10 bps. We currently recommend two tactical trades designed to profit from movements in the Treasury curve. First, we have been recommending a short position in the July 2018 fed funds futures contract since July 11.7 From current levels, we calculate this trade will deliver an un-levered return of 28 bps if there are two hikes between now and then, and 53 bps if there are three hikes. Our second recommendation is a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell, a trade designed to profit from a steepening of the 2/10 yield curve. It remains our view that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve. We expect the 2/10 slope to steepen as inflation rebounds during the next few months. Two weeks ago we published a Special Report 8 that explained our rationale for taking views on the slope of the curve using butterfly trades. It also explained our butterfly spread valuation model, and how we use that model to determine how much steepening/flattening is currently discounted in the yield curve. According to our model, the curve is priced for 9 bps of 2/10 steepening during the next six months (Chart 7). Our recommended butterfly trade will earn positive returns if the curve steepens by more than that. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in July. The 10-year TIPS breakeven inflation rate rose 9 bps on the month and, at 1.8%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Core inflation has moved sharply lower since February, but the fact that our Phillips Curve model of core inflation has not rolled over makes us inclined to view the downtrend as transitory. Also, during the past few weeks we have seen some preliminary signs that inflation is on the cusp of rebounding. Year-over-year core PCE inflation ticked higher in June for the first time since January. The PCE diffusion index, which has a good track record capturing near-term swings in core PCE, moved sharply higher (Chart 8). The prices paid components of the ISM manufacturing and non-manufacturing surveys increased from 55 to 62 and from 52.1 to 52.7, respectively, in July. We expect stronger realized inflation will lead TIPS breakevens higher during the next few months. However, even in a scenario where core inflation fails to rebound, the downside in breakevens from current levels is limited. The reason is that if inflation remains very low, the Fed will most likely refrain from hiking rates in December. Such a dovish capitulation from the Fed would put upward pressure on breakevens at the long-end of the curve. We discussed this possible scenario in more detail in a recent report.9 ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in July, bringing year-to-date excess returns up to 59 bps. The index option-adjusted spread for Aaa-rated ABS held flat on the month, and remains well below its average pre-crisis level. The Federal Reserve released its Q2 Senior Loan Officer Survey last week. It showed that credit card lending standards moved back into "net tightening" territory after having eased the previous quarter (Chart 9). Auto loan lending standards tightened on net for the fifth consecutive quarter. Tightening lending standards are usually a response to deteriorating credit quality, and thus tend to correlate with higher losses and wider spreads. In that regard, net loss rates for auto loans continue to trend higher, and Moody's data show that the cumulative loss rate for prime auto loans originated in 2017 is worse than for any vintage since 2009, for loans with the same age. Conversely, the mild tightening in credit card lending standards has so far not translated into rising charge-offs (Chart 9), but the situation bears close monitoring. For now, we are content to remain overweight ABS given the attractive spread pick-up compared to other similarly risky sectors. However, we also recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans, even though auto loans now once again offer an attractive spread differential, after adjusting for differences in duration and spread volatility (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 39 basis points in July, bringing year-to-date excess returns up to 96 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, and remains below its average pre-crisis level. The Fed's Q2 Senior Loan Officer Survey showed that lending standards for all classes of commercial real estate (CRE) loans tightened, on net, for the eighth consecutive quarter. The survey also reported that demand for CRE loans is on the decline (Chart 10). The combination of tighter lending standards and weak loan demand suggests that credit concerns continue to mount in the private CMBS space. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to 65 bps. The average option-adjusted spread for the Agency CMBS index held flat on the month but, at 49 bps, the sector continues to look attractive compared to other similarly risky alternatives.10 Not only does the sector offer attractive spreads, but the agency guarantee and the lower delinquency rate in multi-family loans compared to other CRE loans (panel 5) makes its risk/reward profile particularly appealing. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.62% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.63%. The U.S. PMI bounced back in July, after having trended lower for most of this year. The Chinese PMI also increased last month, while the Eurozone reading moderated somewhat from a very high level (panel 4). Overall, the Global PMI came in at 52.7 in July, up from 52.6 in June. Bullish sentiment toward the U.S. dollar has also fallen sharply in recent weeks (bottom panel). Bearish dollar sentiment in an environment of expanding global growth sends a very bond-bearish signal. It means that the entire world is participating in the global expansion and any increase in Treasury yields is less likely to be met with an influx of foreign buying. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.26%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Range calculated using monthly data, specifically the final day of each month. 2 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 3 Ranges for junk spread and VIX calculated using monthly data, specifically the final day of each month. 4 Please see Emerging Markets Strategy Weekly Report, "The Case For A Major Top In EM", dated July 12, 2017, available at ems.bcaresearch.com 5 Mexico carries the largest weight in the Sovereign index, accounting for 23% of market cap. 6 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights The euro area's growth prospects, adjusted for population, are no different to any other major developed economy. If the euro area continues its recovery to just the mid-point of its long-term relative growth cycle... ...the yield spread between long-dated bonds in the euro area and the U.S. will compress to around -50 bps from today's -150 bps... ...and euro/dollar will eventually rally to over 1.30. Stay overweight euro area Financials and Retailers versus U.S. Financials and Retailers. Feature ChartThe Euro Area Has Surged Because Expectations ##br##For The Euro Area's 'Terminal' Interest Rate Have Surged Feature The latest GDP releases confirm that the euro area has comfortably outperformed other major developed economies this year. Yet among mainstream equity indexes the Eurostoxx50, which is up 6%, has comfortably underperformed both the MSCI World index1 and the S&P500, which are up 9% and 11%. Why? One clue comes from the technology-heavy NASDAQ 100, which is up 21%. Whereas euro area equities have a negligible exposure to technology, the S&P500 has more than a quarter of its market capitalization in the strongly performing tech and biotech sectors (Chart I-2). Then there is the effect of the surging euro. The largest euro area companies are multinationals earning dollars. In dollar terms, euro area profit growth2 has indeed outperformed U.S. profit growth by about 10%. But converted back into euros - the base currency of the Eurostoxx50 - the outperformance has become an underperformance (Chart I-3). Chart I-2When Technology Outperforms, The Eurostoxx50 Underperforms Chart I-3Euro Area Profits Have Outperformed In Dollars, ##br##But Not In Euros Play Relative Economic Performance Through Bonds And Currencies Chart I-4Euro Area Banks Have Outperformed U.S. Banks The salutary lesson is that sector and currency effects always swamp relative economic performance in predicting or explaining the relative performance of mainstream equity indexes. To play the euro area's economic outperformance, global equity investors must drill down to the more domestically driven euro area sectors, financials and retailers. An overweight position in these two domestic sectors versus their equivalents in, say, the U.S. has outperformed this year, and should continue to do so (Chart I-4). But the best way to play relative economic performance is through other asset classes. Focus not on equities, but on government bonds and currencies. In line with the euro area's superior economic performance this year, the spread between long-dated bond yields in the euro area and U.S. has compressed by 45bps, and euro/dollar is up 12%. The good news is that these trends can ultimately run much further. He That Is Without Structural Problem, Cast The First Stone... Chart I-5For American Men, Labour Force ##br##Participation Rate Is Collapsing The obvious pushback to the longer-term narrative is: what about the euro area's much discussed structural difficulties? To which our response is yes, the euro area does face undoubted long-term challenges. Integrating 19 disparate nations into the confines of an ever closer financial, economic, and ultimately political union is a task that comes with difficulties and risks, especially in the political dimension. Having said that, the euro area is not the only major economy contending with major financial, economic and political challenges in the coming years. To paraphrase the Bible, "he that is without structural problem among you, let him cast the first stone at the euro area." The United Kingdom will spend the next few years struggling to define and redefine the meaning of Brexit, then trying to negotiate it, and then grappling to implement it - whatever 'it' ends up being. The whole process is fraught with financial, economic and political challenges and dangers. Looking West, the United States is suffering a major structural downtrend in its labour participation rate; for American men especially, the participation rate is collapsing (Chart I-5), which creates its own political problems. Looking East, Japan is suffering a chronically low and declining birth rate. And China must wean itself off a decade long addiction to debt-fuelled growth. We could go on... Seen in this light, are the euro area's structural challenges really any harder (or easier) than those faced by the other major economies? The Euro Area Is An Economic Equal One important differentiator across the major developed economies is population growth. A population that is growing boosts headline output. On the other hand, it also adds to the number of people who must share the economy's income and resources. Conversely, a population that is shrinking weighs on headline output, but it reduces the number of people who must share the income and resources. Therefore, what matters for standards of living - and the consequent political implications - is the evolution of GDP per head. In a similar vein, a growing population means that a firm will see rising sales. But absent a rise in productivity, the firm will have to employ more staff and capital to deliver those increased sales - in other words, issue more shares. Therefore, what matters for earnings per share is the evolution of productivity, which once again means GDP per head. Some people consider a shrinking population as a particular problem. They argue that when a population is shrinking, the economy needs to shed workers and capital, which can be hard to do. But a growing population can also create disruptions and pains: specifically, resources such as housing and public services might struggle to keep pace with rapidly rising demand. Consider the United Kingdom. In the 1980s and 90s, the population grew at a very sedate 2% per decade. But since the millennium, population growth has almost quadrupled to 7.5% per decade. The resulting strain on housing and public services was a major factor behind the vote for Brexit - which of course, now carries its own disruptive consequences. Chart I-6The Euro Area Is An Economic Equal Therefore, population shrinkage or growth is a problem only if it is sudden or extreme. More modest changes in either direction are neither good nor bad per se. But to assess progress in living standards and indeed equity market profitability, it is crucial to measure economic growth adjusted for population change. On this population adjusted basis, the structural growth prospects of the euro area are not meaningfully different to other developed economies such as the U.K. and the U.S. The euro area is an equal, and recently it has been the first among equals. Over the longer term, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-6). Within the bigger picture, the euro area has underperformed through multi-year periods encompassing around half the time; and it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance was the impact of back to back recessions separated by an unusually short gap, with the second of the two recessions the direct result of policy errors specific to the euro area. In other words, the euro area's 2008-14 economic underperformance was not structural; it was cyclical. Prospects For Bond Yield Spreads And The Euro If the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends ultimately have much further to run. Unsurprisingly, relative interest rate expectations closely follow relative real GDP per head. Relative interest rate expectations 2 years out between the euro area and United States have compressed from -230 bps last December to -185 bps today. Relative interest rates expectations 5 years out have compressed more, to -150 bps today (Feature Chart). This makes perfect sense. Clearly, the ECB will not hike interest rates any time soon, but expectations for the long-term 'terminal' rate have correctly gone up from overly-pessimistic levels. Nevertheless, to reach the mid-point of its long-term cycle, the gap between euro area and U.S. interest rate expectations must ultimately get to around -50 bps (Chart I-7). The implication is that the yield spread between long-dated bonds in the euro area3 and the U.S. will also compress to around -50 bps (Chart I-8). Therefore, on a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. This also carries repercussions for euro/dollar, given that it closely tracks relative interest rate expectations. The mid-cycle gap of -50 bps equates to euro/dollar at over 1.30 (Chart I-9). And an overshoot to the top of the cycle implies over 1.50. Chart I-7Relative GDP Per Head Leads Relative Interest Rate Expectations Chart I-8...And Bond Yield Spreads Chart I-9Relative Interest Rate Expectations Drive Euro/Dollar But trends do not unfold in straight lines. They are punctuated by regular setbacks. The recent surge in euro/dollar has taken its 65-day fractal dimension towards its lower limit, which suggests excessive short-term herding. That said, we could now be at the mirror-image turning point in ECB policy to that of the summer of 2014. Then, Draghi pre-announced QE; now, he may pre-announce its demise. In which case, fundamentals will override the 65-day fractal signal just as they did three years ago (Chart I-10). Nonetheless, we would not be surprised if euro/dollar first revisited the 1.10-1.15 channel before resuming its long march upwards. Chart I-10Excessive Short-Term Herding In Euro/Dollar, But... Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In local currency terms. 2 Based on 12 month forward earnings per share. 3 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. Fractal Trading Model* This week's trade is to position for an underperformance of Chinese shares versus the emerging markets benchmark. Target a 2.5% profit target and 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-11 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Chart II-7Consumer Staples Chart II-8Energy Chart II-9Financials Chart II-10Health Care Chart II-11Industrials Chart II-12Materials Chart II-13Real Estate Chart II-14Utilities Chart II-15Technology Chart II-16Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen TechnicalsChart III-21Euro/Yen Technicals Chart III-20Euro TechnicalsChart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China
Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Chart 9Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... Chart 11... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008 and 6.7 points higher outside of Germany (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate Sweden's Riksbank. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar. Bond investors should underweight Swedish government bonds versus a European or global benchmark, currency hedged. Equity investors should remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. The risk of persistent inflation will rise only after the next severe global downturn. Feature "Is the 2% inflation target still a very realistic aim?" - Ewald Nowotny, ECB Governing Council member As the ECB Governing Council gathers for its latest monetary policy meeting, some voices within its ranks are starting to question the ECB's first commandment: the 2% inflation target. Respected and influential ECB Governing Council member, Ewald Nowotny, has asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." Across the Baltic Sea, Sweden's Riksbank is one step ahead. Recently, it suggested (re)introducing a variation band of 1% either side of the 2% inflation target1 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve (Chart of the Week). More concerning, the single-minded pursuit of 2% inflation creates risks and instabilities. The Riksbank's inflation target has forced it into an absurd position: with inflation undershooting for over five years, the policy interest rate is now at -0.5% when Swedish GDP growth was recently running at a world-beating 4.5% clip (Chart I-2). Chart I-1Mission Impossible:##br## 2% Inflation Chart I-2Absurd: Interest Rate At -0.5% ##br##When Growth Is At 4.5% Hence, Riksbank Governor, Stefan Ingves, recently proposed that "central banks should also have the explicit responsibility for financial stability." The former governor of the Bank of Japan, Masaaki Shirkawa agrees. "My worry with setting a precise number (of 2%) is that it can crowd out other very important considerations, such as financial stability." What's So Special About 2% Inflation Anyway? Given the almost religious significance of the 2% inflation target for central banks, you would think that there is a well-established theoretical and empirical basis both for inflation targeting and for the 2% number. But you would be wrong. As we explained two years ago in our special report Mission Impossible: 2% Inflation,2 inflation targeting only became established in the 1990s, and the magic 2% number was pulled out of the air. Chart I-3The Riksbank Has Undershot ##br##Its 2% Inflation Target For 5 Years At the Federal Reserve's July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1% (because measured inflation slightly overstates true inflation.) But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1%, the zero-bound of interest rates would prevent "real interest rates becoming negative on the rare occasions when required to counter a recession." Yellen's pragmatism won the day, and Greenspan summarized "we have now all agreed on 2%" Meanwhile in Europe, the ECB's original inflation target of below 2% was close to Greenspan's proposal of 0-1%. But in 2003 the ECB changed its inflation target to its current "below but close to 2%". The reason, according to Mario Draghi: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%." Hence, the Fed, ECB and other central banks are targeting inflation at a low but arbitrary number, 2%, to always allow some leeway for negative real rates; and in the case of the ECB, to allow easier convergence among disparate euro area economies. But as the Riksbank and other central banks have now acknowledged, trying to hit and hold inflation at a point target of 2% is both futile and dangerous (Chart I-3). Why 2% Inflation Is A Mission Impossible The crux of the issue is that inflation is a notoriously non-linear phenomenon. A defining feature of a non-linear phenomenon is that you cannot just turn it up or down like the volume dial on your music system. Non-linear phenomena experience sudden and violent phase-shifts from stability to instability, making it very difficult to hit and hold a point target like 2%. To experience this difficulty for yourself, try pulling a brick across a table using an elastic band. Initially, the brick doesn't move because of the friction with the table. But at a tipping point the brick does move, and the friction simultaneously decreases, self-reinforcing the brick's acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability - the brick doesn't move - to violent instability - the brick hits you in the face! Try as hard as you might, it is near-impossible to pull the brick across the table at a constant speed of, say, 2mph. A very similar dynamic applies to inflation. The system suddenly phase-shifts from stability - near-zero inflation - to violent instability. It is near-impossible to keep inflation at an arbitrary constant of, say, 2%. To understand why, consider the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. Theoretically and empirically, both M and V are notoriously non-linear phenomena (Chart I-4, Chart I-5, Chart I-6, Chart I-7) - because they are subject to the same conditions as the brick pulled by an elastic band: inertia, then self-reinforcement with delayed controlling feedback. Chart I-4The Velocity Of Money... Chart I-5...Is A Non-Linear Phenomenon Chart I-6The Money Multiplier... Chart I-7...Is A Non-Linear Phenomenon As policymakers try to take inflation away from its natural state of near-zero, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible. Hence, the product MV experiences an even sharper non-linearity. Well-intentioned policymakers would think they could apply a controlling feedback to MV. But how? Economic and monetary data are noisy, imprecise and take time to collect and parse. As we have shown, inappropriate and/or delayed feedback just adds to the system's instability. Seen in this light, inflation-targeting in the 1990s worked because central banks were just helping economies move from an unnatural state - uncontrolled inflation - towards a natural state - price stability (Table I-1 and Chart I-8). But now that economies have reached a natural near-zero inflation rate, point targeting an unnatural inflation rate is both futile and dangerous. Table I-1For 700 Years U.K. Inflation ##br##Averaged Near-Zero Chart I-8Excluding Wars, Persistent Inflation Was ##br##Very Unusual... Until The Late 20th Century The Investment Implications The ECB's Nowotny argues that "the 2% inflation target should include a certain flexibility." The Riksbank's Ingves agrees, and adds that extreme and unprecedented loose monetary policy endangers financial stability. Central banks tend not to volte-face as it damages their credibility. But to us, it is clear that the ECB and Riksbank are switching their focus from sub-2% inflation to their economies' robust growth. And to the risk that ultra-accommodative policy poses to financial stability and market distortion. Hence, the era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate the Riksbank whose policy has inevitably mirrored Frankfurt - for fear of a sharp appreciation of the Swedish krone versus the euro. Our currency mantra this year has been "euro first, pound second, dollar third." The strategy has performed extremely well, and into this mix we can add the Swedish krone. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar (Chart I-9). Chart I-9Long SEK/USD Is An Alternative ##br##To Long EUR/USD Chart I-10Underweight Swedish Bonds Is An Alternative To Underweight German Bunds The bond market corollary is to underweight Swedish government bonds - just like German bunds - versus a European or global benchmark, currency hedged (Chart I-10). The equity market implication is to remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. Finally, given that inflation could ultimately phase-shift to violent instability, when should we worry about it? Not yet. To expand the broad money supply, someone has to borrow money. So if policymakers really want to create rampant inflation, the government has to borrow and spend money at will,3 with the central bank creating it. In other words, the central bank loses its independence and fiscal policy becomes irresponsibly loose. The risk of this remains low until the next severe downturn - when policymakers may be forced into desperate measures for a desperate situation. Until then, own some bonds. Our preference is Spanish Bonos and U.S. T-bonds. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 2 Published on August 20, 2015 and available at eis.bcaresearch.com. 3 For example, by giving all public sector workers a 50% pay rise! Fractal Trading Model* The sell-off in Spanish media (Mediaset Espana Comunicacion) is technically overdone. This week's trade is to go long Mediaset Espana Comunicacion versus the market with a 5% profit-target and symmetric stop-loss. In other trades, long FTSE100/short IBEX35 hit its 4% profit-target, while short EUR/USD hit its 2% 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-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Chart 3U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Chart 5France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index