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Overweight (High Conviction) In what has become a surprisingly repetitive narrative, global trade bellwether Caterpillar reported results yesterday that beat analyst expectations and lifted their full-year guidance. Management noted that global demand is robust enough for the company to push through price increases that more than offset higher tariff-related input costs; this is well reflected in volumes (second panel). We view these results as further confirmation that BCA's synchronized global capital spending macro theme remains fully intact and will continue to underpin the S&P construction machinery & heavy truck (CMHT) index. We take our cue from our machinery EPS model which suggests an earnings-led rally is in the offing (third panel), supported by firming commodity prices (top panel). We reiterate our high-conviction overweight recommendation on the S&P CMHT index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR.
Highlights Editor's Note: I am pleased to return to U.S. Investment Strategy (USIS). I worked with the service when I joined BCA in 2010, and previously led it from August 2013 through September 2014. Sara Porrello, who has been with the team for over 20 years, and I look forward to re-aligning USIS with its original mandate. We hope you will find it consistently insightful. Best regards, Doug Peta U.S. Investment Strategy is getting back to basics: Today's report, plainly stating our position on the near-term direction of interest rates, is the first in an ongoing series meant to stake out our views on the macro issues that are most important to investors. Rates are headed higher, consistent with a booming economy that may well overheat, ... : Assuming trade tensions don't short-circuit the expansion, the U.S. economy is poised to grow above trend well into 2019. ...thanks to a tightening labor market and dubious fiscal spending, ... : Employers will be forced to bid up wages as the pool of idled and under-utilized workers dries up, and the fiscal stimulus package is all but certain to goose inflation pressures. ... and neither tweets nor testy interviews nor other expressions of presidential pique are likely to stay the Fed from its appointed rounds: The Federal Reserve cherishes its independence, and it is extremely unlikely to bow to presidential pressure. Feature U.S. Investment Strategy is meant to provide analyses of the U.S. economy and its future direction for the purpose of helping our clients make asset-allocation decisions. Starting with this report, we are going back to the basics of meeting that mandate. Over the rest of the summer, we intend to outline our positions on the key macro drivers of financial markets: rates, credit, the business cycle, and the state of monetary policy. Laying out our big-picture views, and the rationale underpinning them, will establish a framework for evaluating incoming data. The goal is to allow our clients to think along with us as new information is disseminated, and to distinguish signals from noise. We also want to make it easier for clients to anticipate the evolution of our views. To that end, will make frequent use of checklists highlighting the specific elements that might lead us to change our take on the evolution of the key cycles. The ultimate goal is to stay on top of cyclical inflection points, and to use them to inform asset-allocation decisions. The Fed Gets Its Way On Rates Monetary policy is a blunt instrument that works with indeterminate lags, and its effect has been roundly questioned. At the ends of the armchair-quarterback continuum, the Fed is mocked as a clueless bumbler, turning dials at random like a fumbling Mr. Magoo, or bemoaned as an omnipotent manipulator of financial markets and real-world activity. Strictly speaking, it controls nothing more than short rates. As its post-crisis communications strategy has shown, however, its reach extends well beyond its official policy-rate dominion. Talk of last decade's "conundrum" aside, changes in the fed funds rate reverberate along the entire yield curve. As the Chart Of The Week demonstrates, the aggregate yield on all outstanding Treasury issues is joined at the hip, directionally, with the fed funds rate. Aggregate weighted-average Treasury duration sits squarely in the belly of the curve, and it is a not-quite-perfect proxy for the long end, where the Fed's gravitational pull wanes (Table 1). Its pull is still powerful, though; the 90% correlation between the fed funds rate and the 30-year bond testifies eloquently to the Fed's significant influence at all points of the curve (Chart 2). Chart of the WeekThe Fed Gets Its Way The investment takeaway is that the Fed gets what it wants across the full spectrum of rates the vast majority of the time. Given the FOMC's repeatedly expressed intention to continue on its normalization course, the path of least resistance for rates at all maturities is higher. Despite the money markets' resistance to extrapolate the 25-bps-a-quarter "gradual pace" across the rest of this year and next (Chart 3), six more quarters of that pace is our baseline expectation provided an economic shock does not occur. Investors should be prepared for a higher peak in the fed funds rate than the consensus expects. Table 1Correlation With The Fed Funds##BR##Rate By Bond Maturity Chart 2The Long Arm##BR##Of The Fed Chart 3Rates Have Room To##BR##Surprise To The Upside Bottom Line: The Treasury curve faithfully reflects changes in the fed funds rate. In the absence of a shock that would cause the FOMC's repeatedly expressed plans to change, monetary policy is a catalyst for higher rates. But What About An Inverted Yield Curve? The yield curve typically inverts in the latter stages of a rate-hiking campaign, so it is more correct to say a higher fed funds rate implies higher Treasury yields until the yield curve inverts. An inverted yield curve is a classic recession indicator, albeit often a very early one (Table 2), and it should not be taken as a signal to immediately de-risk portfolios. The yield curve may be prone to invert even earlier than it otherwise would this time around, given that QE1, QE2, and QE3 may well have depressed the term premium on long-term bonds,1 as The Bank Credit Analyst noted in its August edition. The question of how much the Fed's asset purchases have affected the term premium, if at all, is far from settled within either the Fed or BCA, but its potential to impact the signal from the yield curve reinforces our conviction to look to other indicators to confirm its recession message before declaring the end of the bull markets in equities and spread product. Table 2The Yield Curve Is Early The Inflation Outlook As the tepid post-crisis expansion has stretched on and on, investors have grown accustomed to sleepy inflation readings and begun to regard the prospects for a pickup in inflation with skepticism, if not outright disdain. Even within BCA, there has been spirited debate about the relevance of the Phillips Curve - the formalization of the idea that there is an inverse relationship between wage growth and the unemployment rate. Despite the stagflation of the 1970s and the lengthy post-crisis dry spell that have undermined the Phillips Curve's credibility with the rigorously empirically-minded, we do not find it controversial. The relationship between unemployment and compensation may not be perfectly linear, but the Phillips Curve is nothing more than an extension of the laws of supply and demand to wage negotiations. We can accept that the Phillips Curve is kinked - that compensation growth is utterly indifferent to changes in the unemployment rate when labor supply is glutted (as can be seen in Chart 4 when covering all of the observations below 7%), but rather sensitive to its moves when it is in the neighborhood of full employment (as can be seen when covering all of the observations above 5%). We believe the U.S. labor market has reached the point at which employers will have to compete fiercely to attract new talent. After nine years, the economy has finally worked down nearly all of the hidden slack that had padded the broader U-6 unemployment rate.2 The pool of discouraged workers - those who are not counted as officially unemployed because they're not actively looking for a job, but would start tomorrow if offered one - has shrunk below its 2000 and 2007 levels (Chart 5, top panel). Similarly, the share of the labor force that is working part time but would prefer to be working full time is approaching its pre-crisis bottom (Chart 5, bottom panel). The prospects for inflation gained another boost last December upon the passage of the spending package on the coattails of the tax-cut bill. The U.S. economy is poised to receive a substantial dose of fiscal stimulus this year and next (Chart 6). Mainstream macroeconomic thought holds that stimulus injected into an economy that is already operating at full capacity is prone to kindle inflation.3 Chart 4The Phillips Curve Can't Handle Copious Slack ... Chart 5... But Almost All Of It Has Been Worked Off Chart 6Goosing Inflation Along With Output Bottom Line: The U.S. labor market has tightened considerably and competition between employers to attract scarce talent should soon translate to a pickup in wage growth. Unneeded fiscal stimulus is also likely to push prices higher. There are plenty more inflation green shoots behind the ones that have already begun to emerge. White House-Fed Tension Is Nothing New It is not beyond the realm of possibility that presidential pressure could deter the Fed from following through on its intentions and present a risk to our above-consensus terminal rate estimate. The bond market immediately discounted the potential of a less independent Fed by selling off at the long end after the president stated he was "not thrilled" with ongoing rate hikes in an interview with CNBC. There would seem to be little doubt that a captive Fed would be more reluctant to remove the punch bowl than a Fed which was free to pursue its inflation mandate without outside interference. After all, elected officials would be happy to trade long-term pain for near-term gain (at least through the next campaign). The president may have upended convention by publicly airing his displeasure, but there is a natural tension between the White House and the Fed. There have been dust-ups in the past, and there will be dust-ups in the future for as long as elected officials shudder at the thought of an economic downturn. Alan Greenspan wrote frankly in his memoir about friction with the first Bush administration, which included public criticism from the sitting president. "I do not want to see us move so strongly against inflation that we impede growth," President Bush told the press at the beginning of his term, in response to hawkish congressional testimony from Greenspan.4 By all accounts, however, the conflict between Bush père and Greenspan was of a lower-pressure variety than the conflicts between LBJ and William McChesney Martin, and Nixon and Arthur Burns. The legendarily intimidating LBJ summoned Martin to his ranch following an unwelcome rate hike. According to several accounts (and consistent with his longstanding negotiating practices in the Senate), LBJ backed the smaller Martin up against a wall before giving full voice to his complaints. Martin did not budge, pointing out that the Fed had acted in accordance with the legislation governing its actions.5 If Martin represents the heroic Fed chief, standing his ground in the face of heavy pressure from a larger-than-life figure, Arthur Burns is the poster child for folding like a cheap lawn chair. The Nixon tapes capture Nixon and his proxies repeatedly pressuring Burns to prime the pump ahead of the 1972 election, which Burns ultimately did.6 Our view is that Fed Chair Powell is more likely to follow Martin than Burns. The Fed is more transparent today, and its independence is more firmly established than it was in the 1970s. Even if Powell were amenable to doing the president's bidding, he would be held back by the realization that it would ultimately be self-defeating: any hint of political manipulation in the rate-setting process would risk a bond market riot that would blast rates far beyond the levels where a 3.5% fed funds rate would take them. Bottom Line: We are not concerned that the FOMC will yield to pressure from the White House to back away from their rate hike plans. Attempted influence of the Fed is nothing new, and investors need not worry about it now. Investment Implications If we are correct in our view that rates have not yet peaked, the bond market is likely to face continued headwinds. Long-dated Treasuries will come under more pressure than shorter-maturity issues. Thanks to positive carry, spread product will be less vulnerable to higher rates, but our bond strategists are lukewarm on the risk-reward offered by investment-grade and high-yield bonds given the late stage of the cycle and historically tight spreads. We acknowledge the potential seriousness of the current spate of geopolitical risks, headlined by trade tensions, and advocate temporarily de-risking portfolios in line with the BCA house view (equal weight equities, underweight bonds, overweight cash). We are more constructive than the BCA consensus, however, because we remain constructive on the business cycle, the monetary policy cycle, and the credit cycle. If the key cycles aren't over, the equity bull market probably isn't over, and neither spread widening nor a pickup in defaults is likely to wipe out spread product's excess returns. We will express all of our calls in a basket of ETF recommendations once we have completed our review of the most impactful macro questions, but for now we recommend maintaining below-benchmark positioning in Treasury portfolios while overweighting TIPS at the expense of nominal Treasuries. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument. 2 In the monthly employment report, the headline unemployment rate, which includes only jobless workers who are actively seeking work, is labeled U-3 unemployment. The U-6 series broadens the definition of unemployment to include the jobless who aren't actively searching and those who are working part time only because they cannot find a full-time position. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com, for a discussion of fiscal multipliers under a range of scenarios. 4 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.113. To this day, several members of the G.H.W. Bush administration continue to pin a large measure of blame for its 1992 electoral loss on overly conservative monetary policy. The ex-president himself, in a 1998 television interview, said, "I reappointed him [Greenspan], and he disappointed me." 5 Granville, Kevin. "A President at War With His Fed Chief, 5 Decades Before Trump," New York Times, June 15, 2017, page B3 (updated July 19, 2018). https://www.nytimes.com/2017/06/13/business/economy/a-president-at-war-with-his-fed-chief-5-decades-before-trump.html 6 "How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, Vol. 20, No. 4," Journal of Economic Perspectives (Fall 2006). https://fraser.stlouisfed.org/title/1167/item/2388, accessed on July 24, 2018.
Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Sentiment Is Taking Off Overweight (High Conviction) The S&P air freight index has been rebounding this month after being buffeted by the headwinds of a potential trade war. UPS has been the leader upwards after reporting steeply higher quarterly sales as yields have strengthened considerably amid rocketing domestic e-commerce demand. Moreover, the good news is not simply a domestic story as the exceptionally positive U.S. business conditions are matched by soaring global air freight volumes (second panel). Still, fear has reigned in a market that has ignored positive earnings reports and rising sell-side forecasts with the result that the valuation is at a two-decade low and well below both the long term average and the market multiple (third panel). Our technical indicator agrees, signaling that the S&P air freight index has entered oversold conditions. We reiterate our high conviction overweight recommendation on the air freight index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.
Overweight The S&P investment bank and brokers index has been an excellent performer through the early days of the Q2 reporting season as results have generally been besting estimates and the outlook remains solid. Our interpretation of the macro data certainly concurs. The M&A cycle has continued to grow apace, which is a typical late cycle dynamic, and should continue to underpin top line growth (second panel). At the same time, a recovery in volatility has taken hold, which should keep trading desks busy and continue to push trading revenues higher (third panel). Further, investors are taking on increasing amounts of margin debt, which is now more than 50% higher than the previous cyclical peak (bottom panel). All of this should translate into continued earnings outperformance; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, SCHW, GS, RJF, MS.
Underweight The S&P airlines index got a rare respite last week when United Airlines reported strong results and, perhaps more importantly, scaled back capacity growth plans. Regarding the latter, recall that earlier this year the company had announced a significant expansion, triggering fears of a return to the bad old days of industry overindulgence and a fare war. With respect to the earnings themselves, ticket prices appear to be more resilient than we had feared and are mostly offsetting fuel price increases; airfare's declining share of the consumer's wallet looks to have bottomed (second panel). Further, higher prices are not impacting the operating efficiency gains of the past five years as load factors are still near peak levels (third panel). The upshot is that margins may soon arrest their descent (bottom panel); we reiterate our underweight recommendation with an upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.
