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Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. The 2017 tax bill, rising energy prices, and banks' willingness to lend all suggest strong capital spending this year. Our view is that stagflation is not a near-term threat. Nonetheless, investors are concerned about a return of a period of decelerating growth and rising inflation. We examine the performance of U.S. financials in and out of stagflation. We reexamine the link between inflation, deficits, credit and money supply growth. Feature Chart 11H GDP Tracking Well Above Potential The VIX moved lower last week even as U.S. bond yields rose. Tensions with North Korea re-escalated, but Trump's trade spat with China eased. On balance, the spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. Economic growth prospects in the U.S. remained upbeat. A series of reports for April and May on housing, consumer spending, manufacturing and capital spending all indicated that real GDP growth in Q2 2018 was tracking to over 4% after a 2.3% gain in Q1, well above the economy's potential growth rate of 1.8% (Chart 1). Capital spending remains poised to lift off in 2018 aided by the supply-side impact of the 2017 tax cut bill and higher oil prices. Despite upbeat economic news in the U.S., there were additional signs last week that growth outside the U.S. was slowing.1 This deceleration, coupled with recent readings on wage and price inflation, suggest that investors may be concerned that stagflation is imminent. BCA's view is that the next bout of stagflation is still several years away. In this week's report, we look at the longer-term relationship between inflation, money supply, credit growth and deficits. Early 2018 Volatility Spike: An Update Surges in volatility do not signal either the end of a business cycle or an equity bear market. Moreover, while there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two.2 Nonetheless, 60% of volatility upheavals outside of recessions occurred during the late stages of a business cycle. Thus, the recent jump in volatility is another signal that the economy is in the final stages of expansion. Our November 13, 2017 report discussed financial market volatility and its relationship with the business cycle, monetary policy and economic volatility.3 In that report, we noted that any meaningful pickup in inflation would upset the 'low vol' applecart. Prices of U.S. dollar financial assets have recovered since early February's market turbulence, but are not back to pre-spike levels. Chart 2 shows that at 13.7, the VIX is 63% lower than its early February peak. Neither the stock-to-bond ratio (panel 2) nor the S&P 500 (panel 3) has returned to its late January high, but both have bounced up. Small caps (panel 4) have hit a new record, but emerging market equity prices (in U.S. dollars) have languished. The price of West Texas Intermediate oil reached a fresh cycle high in late March and is now above $70 (Chart 3, panel 2). BCA's Commodity & Energy Strategy service expects West Texas to average $70/bbl this year. Moreover, increasing geopolitical risks to supplies (Venezuela and Iran) raise the chances of WTI prices reaching $80/bbl by the end of the year, with Brent prices threatening $90/bbl.4 Our stance on oil prices this year supports more energy-related capex (see next section). Panel 3 shows that despite higher realized inflation and inflation expectations, gold prices have rolled over since the volatility spike. High-yield spreads briefly returned to their late January lows in mid-April, but are now back to the middle of the range that they have been in since early February (panel 4). The dollar has surged in recent months (panel 5). BCA's view is that the dollar will continue to strengthen as the Fed raises rates more than the market expects and as U.S. economic growth outpaces growth outside the U.S.5 Chart 2The VIX And U.S. Financial Assets... Chart 3...Before And After The February Vol Spike Chart 4 shows three-year rolling correlations between several major U.S. asset classes. The early 2018 volatility spike coincided with a shift in the link between the 10-year Treasury yield and the broad dollar (panel 2). The relationship between Treasury yields and oil troughed prior to the spike and continues to climb (panel 4). Otherwise, the longer-term, cross-asset class correlations in place prior to early February are still in play. Chart 4Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations However, shorter-term correlations within the S&P 500 have shifted (Chart 5). The early February volatility run up marked a bottom in the correlation between sectors, industries and individual S&P 500 stocks. This is consistent with what happened in the wake of volatility spikes in 2010 and 2011, but not following the 2015 episode. Bottom Line: The recent vol spike did not signal the end of the expansion or the bull market. Stay long stocks over bonds. Chart 5Intra-S&P 500 Correlations Shifted After The Vol Spike Soundings From The Supply Side BCA expects the U.S. economy to grow above its long-term potential this year and into next year, further reducing slack in both the product and labor markets, and ultimately pushing up inflation. We discussed the housing and consumer sectors in early May6 and this week, we assess business capital spending. Our recent reports7 discussed the near-term benefits to the U.S. economy from higher government spending, but there are supply side benefits as well. The Congressional Budget Office (CBO) boosted its estimate of the economy's long-run potential growth rate due to the supply-side benefits of lower taxes on the labor market and the immediate expensing of capital outlays. Faster growth in the long run would reduce the projected cumulative budget deficit from 2018-2027 by $1 trillion. The CBO also expects that labor force growth will pick up as lower personal income tax rates encourage workers to work longer hours.8 BCA's view is that capital spending was on the upswing before the tax bill passed last year (Chart 6). Moreover, our model for business capital spending suggests gains even without higher oil prices (Chart 7). Chart 8 shows that banks are easing their lending standards for C&I loans (panel 1) and that higher rates have not yet increased the cost of funding to restrictive levels (panel 2). However, demand has been tepid, although it is still trending higher (panel 3). The tax repatriation portion of the 2017 tax cut may have temporarily reduced businesses' demand for loans. Chart 6S&P 500 Sensitive To Oil ##br##Prices And Oil Driven Capex Chart 7Business Spending Poised To Lift Off Chart 8Supply And Demand For C&I Loans Bottom Line: A surge in U.S. capital spending is likely in the second half of 2018 and into 2019. The rising cost of human capital and sagging productivity are additional incentives for firms to spend on labor-saving equipment. Moreover, increased oil prices will drive additional spending in the energy sector. Our U.S. Equity Strategy team recommends an overweight to the Industrials sector.9 While surging capex this year and next will help to boost productivity in the short run, a comprehensive, economy-wide infrastructure package would be helpful in steering the economy away from stagflation in the long run. Stagflation Scenario BCA's 2018 Outlook10 notes that stagflation may be not be present in the U.S. for several more years, likely not until the early 2020s after the next recession. However, BCA's Global Fixed Income Strategy service states that the global economy may be entering a period of mild stagflation characterized by slowing economic growth and rising inflation.11 Nonetheless, some investors are concerned that a prolonged period of stagflation may ensue. We define stagflation as episodes of decelerating real economic growth and accelerating core inflation (Chart 9). Accordingly, stagflation occurred in the 1960s, 1970s and early 1980s. Since then, there have been an additional six episodes, all of them milder than earlier occurrences. The last bout was between July 2015 and October 2016. Chart 9Risk Assets And Stagflation We show the performance of U.S. financial assets, commodities, the dollar and S&P 500 earnings when stagflation was present (Table 1) and when it was not (Table 2). Note that recessions occurred during four of the stagflationary periods (late '60s/early '70s, early-to-mid '70s, late '70s, and late '90s-to-early 2000s). There were two recessions (early 1980s and 2007-2009) when stagflation did not appear. Table 1Risk Assets, Commodities, Gold Oil And The Dollar During Stagflation Table 2Risk Assets, Commodities, Gold Oil And The Dollar When No Stagflation Is Present U.S. stocks, the stock-to-bond ratio, investment-grade credit and high-yield bonds outperform when there is no stagflation. Small cap performance relative to large caps is also better when stagflation is present. Gold (average gain of 85%) and oil (86%) are the standout performers during these cycles. Without stagflation present, gold rises by only 13% on average and oil prices fall by 11%. The dollar climbs by 4% on average without stagflation and declines by 5% when stagflation develops. Restricting our analysis to only the more benign bouts of stagflation in the past 20 years we find similar results; stocks, the stock-to-bond ratio, investment grade and high yield credit perform better when there are bouts of benign stagflation. A notable exception is that there has been little difference in the performance of gold in or out of stagflation in the past two decades. Bottom Line: BCA expects inflation to reach the Fed's 2% target this year and accelerate in 2019, prompting more aggressive central bank actions in mid-2019 through mid-2020 than the market currently prices in. Increased rates will send the economy into recession in 2020. Stagflation will likely take hold as the economy recovers from that recession. Stay overweight stocks versus bonds for now, but look to pare back exposures later this year. Investors with longer time horizons should begin to prepare for lower real returns in the 2020s after the end of the recession early in the decade. Inflation: A Longer-Term View Some investors are concerned that rising deficits will immediately lead to higher inflation. We take a longer-term approach based on our analysis of the link between inflation and federal government interest payments, private credit growth, money supply growth and federal budget deficits. There is only a loose relationship between federal government interest payments as a share of GDP and inflation (Chart 10). For example, interest payments were high relative to GDP in the 1990s, but inflation was low. In the 1970s, inflation was high while interest payments as a share of GDP were not at an extreme. However, there is a strong connection between the growth of private credit and money supply, and inflation. Chart 11 shows that elevated rates for private credit growth are associated with increased inflation and vice versa. High inflation in the 1970s was accompanied by strong credit growth. In this decade, we have experienced meager private credit creation and very low inflation. Chart 12 shows a similar relationship between M2 growth and inflation. Note that strong M2 growth in the 1970s coincided with high inflation, while minimal growth in money supply in the 1930s was accompanied by deflation. On the other hand, there is only a tenuous connection between deficits as a share of GDP and inflation (Chart 13). In the inflationary 1970s, deficits averaged just 2% of GDP. However, the 1950s and 1960s saw both exceedingly low inflation and deficits. So far in the 2010s, deficits have averaged near 5% of GDP, but inflation has been muted at barely over 1%. Chart 10Long Run Relationship Between Federal ##br##Net Interest Payments And Inflation Chart 11Long Run Relationship Between ##br##Private Credit Growth And Inflation Chart 12Long Run Relationship Between ##br##M2 Growth And Inflation Chart 13Long Run Relationship Between Federal ##br##Budget Deficits And Inflation Moreover, the fiscal stimulus put in place late last year and early this year is likely to push inflation higher as it adds to aggregate demand in an economy that is already at full employment. Bottom Line: BCA expects inflation to reach the Fed's 2% target based on the core PCE measure this year, and move above that goal next year, which would drive up both short and long rates. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Serenity Now," published May 15, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Patience Required," published November 13, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Feedback Loop: Spec Positioning & Oil Price Volatility," published May 10, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Swan Songs," published May 18, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Consumer And Housing Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 7 Please see BCA Research's The Bank Credit Analyst, published May 2018 and U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at bca.bcaresearch.com and usis.bcaresearch.com. 8 https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651… 9 Please see BCA Research's U.S. Equity Strategy Weekly Report "Earnings Take Center Stage," published October 2, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's The Bank Credit Analyst "2018 Outlook - Policy And The Markets: On A Collision Course," published November 20, 2017. Available at bca.bcaresearch.com. 11 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Stagflation-ish," published April 18, 2018. Available at gfis.bcaresearch.com.
Highlights The Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation is either too high or too low, and the current account position is either too large or too small. The global economy has made significant progress in moving towards both internal and external balance over the past few years, but shortfalls remain. A number of large economies, including Japan, China, and Italy, continue to need stimulative fiscal policy to prop up domestic demand. In Italy's case, investor unease about the country's fiscal outlook is likely to raise borrowing costs for the government, curb capital inflows into the euro area, and push the ECB in a more dovish direction. All this will weigh on the euro. The U.S. should be tightening fiscal policy at this stage in the cycle. Instead, President Trump has pushed through significant fiscal easing. This is the main reason the 10-year Treasury yield hit a seven-year high this week. An overheated U.S. economy will pave the way for further Fed hikes, which will likely result in a stronger dollar. Rising U.S. rates and a strengthening dollar will hurt emerging markets. Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Feature The Dismal Science, Illustrated Last week's report discussed the market consequences of the tug-of-war that policymakers often face in trying to achieve a variety of economic objectives with a limited set of policy instruments.1 In passing, we mentioned that some of these trade-offs can be depicted using the so-called Swan Diagram, named after Australian economist Trevor Swan. This week's report delves further into this topic by estimating where various economies find themselves inside the Swan Diagram, and what this may mean for their currency, equity, and bond markets. True to the reputation of economics as the dismal science, the Swan Diagram depicts four "zones of economic unhappiness" (Chart 1). Each zone represents a different way in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). This amounts to saying that an economy can suffer from one of the following: 1) high unemployment and an excessively large current account deficit; 2) high inflation and an excessively large current account surplus; 3) high unemployment and an excessively large current account surplus; and 4) high inflation and an excessively large current account deficit. Box 1 describes the logic behind the diagram. Chart 1Four Zones Of Unhappiness BOX 1 The Logic Behind The Swan Diagram As noted in the main text, the Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation are either too high or too low, and the current account balance is either too large or too small. A rightward movement along the horizontal axis can be construed as an easing of fiscal policy, whereas an upward movement along the vertical axis can be thought of as an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule, which corresponds to the ideal state where the economy is at full employment and inflation is stable, is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order to keep the economy from overheating. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. A depreciation of the currency via an easing in monetary policy is necessary to bring imports back down. Any point to the right of the internal balance schedule represents too much inflation; any point to the left represents too much unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Note that according to the Swan Diagram, an economy that suffers from high unemployment may still need a weaker currency even if it already has a current account surplus. Intuitively, this is because a depressed economy suppresses imports, leading to a "stronger" current account balance than would otherwise be the case. We use two variables to estimate the degree to which an economy has diverged from internal balance: core inflation and the output gap (Chart 2). If the output gap is negative, the economy is producing less output than it is capable of. If the output gap is positive, the economy is operating beyond full capacity. All things equal, high core inflation and a large and positive output gap is symptomatic of an economy that is showing signs of overheating. Chart 2The Two Dimensions Of Internal Balance When it comes to estimating the extent to which an economy is deviating from external balance, we include both the current account position and the net international investment position (NIIP) in our calculations (Chart 3). The NIIP is the difference between an economy's external assets and its liabilities. If one were to sum all current account balances into the distant past and adjust for valuation effects, one would end up with the net international investment position. If a country has a positive NIIP, it can run a current account deficit over time by running down its accumulated foreign wealth.2 Chart 3The Two Dimensions Of External Balance Policy And Market Outcomes Within The Swan Diagram Chart 4 shows our estimates of where the main developed and emerging markets fall into the Swan Diagram. The top right quadrant depicts economies that need to tighten both monetary and fiscal policy. The bottom left quadrant depicts economies that need to ease both monetary and fiscal policy. The other two quadrants denote cases where either tighter fiscal/looser monetary policy or looser fiscal/tighter monetary policy are appropriate. In order to gauge progress over time, we attach an arrow to each data point. The base of the arrow shows where the economy was five years ago and the tip shows where it is today. Chart 4Policy Prescription Arising From The Swan Diagram From a market perspective, an economy's currency is likely to weaken if it finds itself in one of the two quadrants requiring easier monetary policy. Among developed economies, the best combination for equities in local-currency terms is usually an easier monetary policy and a looser fiscal policy. That is also the configuration that results in the sharpest steepening of the yield curve. Conversely, the worst outcome for developed market stocks in local-currency terms is tighter monetary policy coupled with fiscal austerity. That is also the policy package that is most likely to result in a flatter yield curve. In dollar terms, a stronger local currency will typically boost returns. This is particularly the case in emerging markets, where stock markets are likely to suffer in situations where the home currency is under pressure. A few observations come to mind: The global economy has made significant progress in restoring internal balance over the past five years. That said, negative output gaps remain in nearly half of the countries in our sample. And even in several cases where output gaps have disappeared, a shortfall in inflation suggests the presence of latent slack that official estimates of excess capacity may be missing. External imbalances have also declined over time. Since earth does not trade with Mars, the global current account balance and net international investment position must always be equal to zero. Nevertheless, the absolute value of current account balances, expressed as a share of global GDP, has fallen by half since 2006 (Chart 5). Chart 5Shrinking Global Imbalances The decline in China's current account balance has played a key role in facilitating the rebalancing of demand across the global economy. The current account showed a deficit in Q1 for the first time in 17 years. While several technical factors exacerbated the decline, the current account will probably register a surplus of only 1% of GDP this year, down from a peak of nearly 10% of GDP in 2007. The Chinese economy also appears to be close to internal balance. However, maintaining full employment has come at the cost of rapid credit growth and a massive quasi-public sector deficit, which the IMF estimates currently stands at over 12% of GDP (Chart 6). Thus, one could argue that a somewhat weaker currency and less credit expansion would be in China's best interest. Similar to China, Japan has been able to reach internal balance only through lax fiscal policy (Chart 7). The lesson here is that economies such as China and Japan which have a surfeit of savings - partly reflecting a very low neutral real rate of interest - would probably be better off with cheaper currencies rather than having to rely on artificial means of propping up demand. Chart 6China's 'Secret' Budget Deficit Chart 7The Cost Of Propping Up Demand Germany has overtaken China as the biggest contributor to current account surpluses in the world. Germany's current account surplus now stands at over 8% of GDP, up from a small deficit in 1999, when the euro came into inception. In contrast to China and Japan, Germany is running a fiscal surplus. Solely from its perspective, Germany would benefit from more fiscal stimulus and a stronger euro. The problem, of course, is that a stronger euro would not be in the best interest of most other euro area economies. While external imbalances within the euro area have decreased markedly over the past decade, they have not gone away (Chart 8). Investors also remain wary of fiscal easing in Southern Europe. This week's spike in Italian bond yields - fueled by speculation that a Five-Star/League government will abandon plans for fiscal consolidation - is a timely reminder that the bond vigilantes are far from dead (Chart 9). The Italian government's borrowing costs are likely to rise over the coming months, which will curb capital inflows into the euro area and push the ECB in a more dovish direction. All this will weigh on the common currency. Chart 8The Euro Club: Imbalances Have Been Decreasing Chart 9Uh Oh Spaghettio! The U.S. is the opposite of Germany. Unlike Germany, it has a large fiscal deficit and a current account deficit. The Swan Diagram says that the U.S. would benefit from tighter fiscal policy and a weaker dollar. President Trump and the Republicans in Congress have other plans, however. They have pushed through large tax cuts and significant spending increases (Chart 10). This will likely prompt the Fed to raise rates more aggressively than the market is currently discounting, leading to a stronger dollar. Chart 10The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Rising U.S. rates and a strengthening dollar will hurt emerging markets, particularly those with current account deficits and negative net international investment positions. High levels of external debt could exacerbate any problems (Chart 11). On that basis, Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Chart 11External Debt And Debt Servicing Across EM Investment Conclusions Chart 12The U.S. Economy Is Doing ##br##Better Than Its Peers The global economy is approaching internal balance, but this may produce some unpleasant side effects. Productivity growth is anaemic and the retirement of baby boomers from the workforce will reduce the pace of labor force growth. In such a setting, potential GDP growth in many countries is likely to remain subpar. If demand growth continues to outstrip supply growth, inflation will rise. Heightened stock market volatility this year has partly been driven by the realization among investors that the Goldilocks environment of above-trend growth and low inflation may not last as long as they had hoped. The U.S. economy has now moved beyond full employment, and bountiful fiscal stimulus could lead to further overheating. This is the main reason the 10-year Treasury yield reached a seven-year high this week. Continued above-trend growth is likely to prompt the Fed to raise rates more than the market expects, which should result in a stronger dollar. The fact that the U.S. economy is outperforming the rest of the world based on economic surprise indices and our leading economic indicators could give the dollar a further lift (Chart 12). A resurgent dollar will help boost competitiveness in developed economies such as Japan and Europe. Emerging markets will also benefit in the long run from cheaper currencies, but if the adjustment happens rapidly, as is often the case, this could exact a short-term toll. For the time being, investors should overweight developed over emerging markets in equity portfolios. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 2 To keep things simple, we assume that a country's Net International Investment Position (NIIP) shrinks to zero over 50 years. Thus, if a country has a positive NIIP of 50% of GDP, we assume that it should target a current account deficit of 1% of GDP; whereas if it has a negative NIIP of 50% of GDP, it should target a current account surplus of 1% of GDP. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Underweight While we continue to recommend a core portfolio overweight in the S&P financials index, the S&P insurance sub-index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Currently, the U.S. and global economies are expanding above trend and, under such a backdrop, investors have historically avoided insurance equities. The top panel of our chart drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, second panel). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF.
Underweight - Upgrade Alert Homebuilders took another beating this week, and it seems as if they cannot catch a break. While the latest NAHB sentiment survey reflected homebuilder optimism, survey participants acknowledged that spiking building material costs are now hurting profitability (lumber prices shown inverted, middle panel). Tack on the recent jump in the 10-year Treasury yield that also pushed the 30-year fixed mortgage rate significantly higher and first time home buyers are, at the margin, getting priced out of the new home market (interest rates shown inverted, top panel). When we recently put the S&P homebuilding index on upgrade alert, we thought most of the bad news was already priced into deflated prices and valuations. However, persistent input cost inflation pressures coupled with additional interest rate increases suggest that patience is warranted before crystalizing relative gains to the tune of 25% since our late-November inception. Worrisomely, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel). We would lean against such exuberance and wait for another breakdown in relative share prices before acting on our upgrade alert. Bottom Line: Shy away from homebuilders for now, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator Chart I-5China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Overweight Quarter-to-date the S&P energy services index is up 12% compared with the 2% rise in the broad market. While the steep rebound in oil prices primarily lies behind such stellar outperformance (top panel), our capex upcycle theme for 2018 should support this nascent recovery. Energy related capital spending budgets are not only rising in the U.S. (primarily in shale oil), but also globally. The global rig count is breaking out, and declining OECD oil stocks suggest that drilling activity will remain robust (second and third panels). Relative share price momentum does not yet fully reflect the rebound in industry investment (using national accounts) that remains in a V-shaped recovery since the Q1/2016 oil market trough (bottom panel). In sum, there are more gains in store for the S&P energy services index. Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Bottom Line: Stay overweight the S&P energy service index and see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5ENRE: NOV, SLB, FTI, BHGE, HAL, HP.
Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Chart 4German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Chart 24Voters Want Governance Improvements The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.
Highlights Global Volatility Vs. Inflation: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Feature Chart of the WeekThe Comeback Kids After a lengthy period of convalescence following the February VIX spike, some calm has been restored to financial markets. Global equities are staging a recovery from the correction seen earlier this year, with major indices like the U.S. S&P 500 and the MSCI All-Country World Index breaking out above key technical levels last week (Chart of the Week). Volatility in developed economy credit has also died down a bit, although corporate bond spreads still remain above the lows of the year in most countries. The resiliency of risk assets is even more impressive when viewed against the continuing climb of oil prices, fueled further by President Trump's announcement last week that the U.S. was pulling out of the Iran nuclear deal. With the benchmark Brent oil price now within hailing distance of $80/bbl, developed market government bond yields remain under upward pressure through higher inflation expectations (bottom panel). Yet as been the case for the past several months, the greatest upward pressure on global bond yields has been seen in the U.S., where the benchmark 10-year Treasury yield is once again knocking on the door of the 3% level. Global growth has lost some momentum in the first few months of the year, but not by enough to cause any loosening of capacity pressures through rising unemployment rates. Until the latter occurs, central banks will remain focused on the slow-but-steady rise in inflation pressures. This will limit any material decline in government bond yields as markets must price in both higher inflation expectations and some degree of interest rate increases. Not every central bank will deliver on what is currently discounted in terms of rate hikes, however, which continues to create more attractive relative fixed income country allocation opportunities now than have been seen in the past few years. We continue to recommend an overall below-benchmark portfolio duration stance, favoring corporate credit over sovereign debt. Within dedicated government bond portfolios, we favor underweight exposures in the U.S., Canada and core Europe while overweighting Australia, the U.K. and Japan. Lower U.S. Volatility Does Not Necessarily Mean Greater Global Stability The surge in market volatility earlier in the year began in the U.S. following the "wage inflation scare" in early February. The idea that dormant U.S. wage inflation could finally have awakened shook markets out of their slumber, driving the VIX index sharply higher (with some nudging from volatility-linked ETFs and other leveraged vehicles). Yet other markets saw a surge in vol, like currencies and the MOVE index of U.S. Treasury option prices (Chart 2). The latter development underscores one of our key investment themes for 2018, which is that the low market volatility environment will end through higher bond volatility.1 Faster U.S. inflation was expected to be trigger for that pickup in U.S. bond volatility, which would lead to a more aggressive path of Fed rate hikes and more uncertainty about the U.S. growth outlook beyond 2018. We did not expect that inflation-driven surge in bond volatility until the latter half of this year, but what happened in early February showed how the investing backdrop can turn ugly once inflation makes a comeback. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks (top panel). Combined with some easing of pressures seen in funding markets through the wider LIBOR-OIS spread (bottom panel), the backdrop is in place for continued recovery in U.S. equity and credit markets. It's a different story in non-U.S. markets, however. Softening global growth in the first quarter of the year, combined with steady increases in U.S. interest rate hike expectations, has resulted in the U.S. dollar staging a recovery after the pounding it took in 2017 (Chart 3). That combination of higher U.S. bond yields, a stronger dollar and weaker growth is a classic toxic brew for Emerging Market (EM) assets, which have been underperforming under the weight of investor outflows. None of those factors looks set to reverse in the near term, and we continue to recommend underweight allocations to EM fixed income (especially corporate debt). Chart 2The VIX Storm Has Blown Over Chart 3Not All Risk Assets Have Been Stabilizing Within the major developed markets, the most important factor at the moment is diverging inflation trends rather than growth. While U.S. inflation continues to drift higher, inflation in the euro area and U.K. has lost momentum (Chart 4). Surprisingly, Japanese inflation has finally started to show a bit of life - even after a period of yen appreciation - but perhaps that is because domestic inflation is finally awakening with annual wage growth hitting a 15-year high of 2.1% in March (3rd panel). Core inflation remains well below the Bank of Japan's 2% target, however. Meanwhile, last week's release of the April U.S. CPI data showed that inflation was still moving higher despite the outcome being slightly worse than expected (Chart 5). Importantly, some large and important elements of the CPI, like Shelter costs (33% of the total CPI index) and core goods prices (20%), saw a pickup in year-over-year inflation in line with our models and leading indicators. Given that U.S. real GDP growth leads core CPI inflation by about five quarters (top panel), this suggests that all of our inflation indicators are pointing to additional increases in U.S. inflation in the next 3-6 months. Chart 4Diverging Trends In Global Inflation Chart 5U.S. Inflation Momentum Still Trending Higher With U.S. inflation heading higher and non-U.S. developed market inflation languishing, there is still much more upside risk for U.S. Treasury yields than for the other government bond markets, mostly via higher U.S. inflation expectations. Stay underweight the U.S. within global hedged bond portfolios and remain long U.S. inflation protection by favoring TIPS over nominal Treasuries. Bottom Line: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: Outperformance To Continue Under New RBNZ Leadership Chart 6Good Timing On Our Bullish NZ Call One of the more successful trade recommendations we have made over the past year was to go long New Zealand government bonds versus U.S. Treasuries and German government debt in May 2017.2 Our call was predicated on a simple premise. The Reserve Bank of New Zealand (RBNZ) would maintain a dovish policy bias far longer than markets were expecting because of subdued inflation, at a time when the Fed would be hiking interest rates and the markets would begin to discount an end to the ECB's asset purchase program. Since we initiated that recommendation one year ago, headline New Zealand CPI inflation has slowed from 1.9% to 1%, while the RBNZ has kept policy rates unchanged. The spread between 5-year New Zealand government debt and 5-year U.S. Treasuries has collapsed from +74bps to -56bps, while the 5-year New Zealand-Germany spread has tightened from 292bps to 234bps. The overall New Zealand government bond index has outperformed the Barclays Global Treasury index by 120bps, currency hedged into U.S. dollars (Chart 6). Looking ahead, it may prove difficult to repeat those numbers from current levels. Yet it is even more challenging to construct a bearish case for New Zealand debt - the economy still looks sluggish, inflation is languishing well below the RBNZ target, and there have been changes at the central bank that will likely keep a dovish bias to New Zealand monetary policy. A Big Shakeup At The RBNZ There are several major moves that have just taken place at the RBNZ that should ensure that the central bank will not be raising rates anytime soon. First, Adrian Orr took over as RBNZ Governor back in March, replacing Graeme Wheeler. Orr was the Chief Executive of the New Zealand government pension (superannuation) fund, but was also a former RBNZ Chief Economist and Deputy Governor. He has stated an intention to make the RBNZ a more open, communicative central bank than Wheeler, who shunned media interviews and limited the number of on-the-record speeches by RBNZ officials. This will make the central bank a more transparent entity and limit the ability of the central bank from doing unexpected policy moves, as it has done in the past. The transparency will increase next year when the RBNZ moves to a full policy committee approach, where interest rates will be decided by a vote rather than a decision solely made by the Governor. Second, the New Zealand government has altered the RBNZ's monetary policy mandate following a review after the victory by the Labour party in last year's election. The central bank must now not only target price stability, but also seek to "maximize sustainable employment" in the New Zealand economy, not unlike the dual mandates of the U.S. Federal Reserve or Reserve Bank of Australia. This marks a major shift for the RBNZ, which was the first central bank to introduce an official inflation target in 1989. This change fulfils the new Labour-led government's campaign promise to promote job creation, which also includes restricting immigration. New Zealand Finance Minister Grant Robertson did state last November that the government would only consider candidates for RBNZ Governor that would be "willing and ready to adopt the new processes" of its review of the RBNZ's policy mandate.3 Robertson also noted that the new framework might result in monetary policy staying more accommodative from time to time. This smacks of increased government pressure on the RBNZ to keep policy as loose as possible to boost economic growth. Governor Orr has already had to go on the defensive, publicly stated that the central bank had "always" been considering short-term swings in employment when making its interest rate decisions. At a minimum, the case for future interest rate increases would have to be very strong under the new policy framework, focused on inflation seriously threatening the upside of the RBNZ's 1-3% target band. Economy Looking Sluggish After last week's monetary policy meeting, where the central bank kept the Overnight Cash Rate at 1.75% and downgraded its growth projections, Orr noted that the markets had "finally seemed to listen" to the RBNZ's message that policy rates would be on hold for a long time. He pointed to the decline in the New Zealand dollar (NZD) to a six-month low following the meeting as a "good thing for a trading nation" like New Zealand.4 His blunt, yet cautious, tone fits with developments in the New Zealand economy of late. Growth slowed over the course of 2017, with real GDP expanding at a 2.9% year-over-year rate in the fourth quarter after averaging 3.5% growth since 2014. The two major drags on growth were consumer spending and residential investment, both of which decelerated from unsustainably high growth rates in the prior few years that were fueled by high rates of net immigration (Chart 7). In the May 2018 Monetary Policy Report (MPR) released last week, the RBNZ noted that it expects net immigration to fall for three reasons: a strengthening Australian labor market, tighter visa requirements and the departure of those with temporary visas.5 The RBNZ is projecting immigration levels will steadily decline over the next four years, returning to levels last seen in 2011 in 2020, which will cause consumer spending growth to slow from over 4% to 2% by the end of the projection period (middle panel). That will also act as a major drag on housing activity, with no significant growth in real residential investment expected until 2020 (bottom panel). This will come on top of other regulatory changes introduced in 2016 to cool an overheated housing market (limiting loan-to-value ratios on mortgage lending). The RBNZ now expects real GDP growth to slow to 2.8% in 2018, a pace below its estimate of potential GDP growth of 3.2%. Not only is consumer spending and housing expected to slow, but the business sector is also projected to remain sluggish. Business confidence and capacity utilization are both well off the 2017 peak, thanks mainly to the slump in the dairy sector, which remains a critical part of the New Zealand economy (Chart 8). The fall in dairy prices and milk production was reportedly caused by poor weather conditions and falling demand from China, but the declines may be bottoming out (bottom panel). Besides the agricultural sectors, manufacturing and service sectors are still in decent shape, with the PMIs for both still above 50 even after last year's declines (top panel). The softer China demand story is not just about dairy, however. Growth in overall export demand from China has slowed dramatically over the past year, from 50% year-on-year down to -4.3% in March (Chart 9, 2nd panel). Australian export demand has also decelerated, which is critical given that those two countries represent 40% of total New Zealand exports. The RBNZ export survey, which has been a reliable leading indicator for New Zealand export growth, shows that exports are likely to continue falling over the next 6-8 months (top panel). With the overall commodity price index have clearly slowed (bottom panel), it is likely that the terms of trade will remain a drag on New Zealand economic growth, and the NZD, through a deteriorating current account deficit (now -3% of GDP) in the coming months. Chart 7Immigration-Fueled Growth Set To Reverse In NZ Chart 8Dairy Still Matters For NZ Chart 9NZ Exports Getting Hit Where's The Inflation? Despite the recent cooling of growth, the New Zealand unemployment rate is well below the OECD's estimate of the full employment NAIRU. Unlike other developed market countries with low unemployment rates, however, New Zealand's labor force participation rate is currently close to an historical high near 71% (Chart 10). While a high participation rate should mean that New Zealand is truly at full employment, wage growth remains anemic even with booming levels of job vacancies (3rd panel). The growth in average hourly pay for overall workers is still below the rate of headline CPI inflation, although this will get a bump with a 4.8% minimum wage increase being adapted last month. Overall, New Zealand's headline CPI inflation reached the RBNZ's target rate only once in Q1 2017, after several years of staying below that 2% benchmark, then started to slow down again over the rest of last year (Chart 11). Currently, headline and core CPI inflation are only 1.1% and 0.9%, respectively. This is now at the lower bound of the RBNZ's 1-3% target band, justifying the central bank's dovish bias. Chart 10Low Unemployment With No Wage Growth Chart 11No Inflation Problems For The New RBNZ Governor Within the main components of the index, non-tradables (i.e. domestically based) inflation has maintained stable growth near 2%, but tradables (i.e. globally based) prices are in outright deflation. This remains the biggest source for the undershoot of the RBNZ's inflation target over the past year - shockingly, a period when oil prices surged higher and the trade-weighted NZD softened. Yet the low levels of inflation are not filtering though into household expectations, with survey data showing that inflation is expected to stay above 2% next year, and even rise to 3% over the next five years. Policy To Stay On Hold For A Lot Longer The RBNZ is not as optimistic as households on inflation, however. The central bank is projecting that the headline CPI index will only rise by 1.1% in 2018 and will not return to the 2% target until 2021. On the back of this, the RBNZ is also projecting that the Overnight Cash Rate will remain at 1.75% until the end of 2020. Chart 12NZ Bonds Will Continue To Outperform The market is still pricing in one 25bp rate hike over the next 12 months, according to our calculations from the Overnight Index Swaps market (Chart 12). We see no reason for the RBNZ to not be taken at its word about holding rates steady, especially given the new dovish elements of the RBNZ's revised mandate. With price and wage inflation still so surprisingly low, the RBNZ can go for its maximum employment mandate and maintain highly accommodative monetary conditions. This includes both low policy rates and keeping the currency as weak as possible. We would recommend leaning against the mild increase in New Zealand bond yields, and the modest flattening of the yield curve, currently priced into the forwards (3rd and 4th panels). That suggests maintaining an above-benchmark duration stance for dedicated New Zealand fixed income investors. It also means adapting a bullish stance on New Zealand government bonds from a relative perspective to other developed markets. We are maintaining our current recommended spread trades for 5-year New Zealand bonds versus 5-year U.S. Treasuries and 5-year German debt. We have maintained the U.S. trade on a currency-hedged basis, as we typically do with all our recommendations. For the New Zealand-Germany spread trade, however, we made a rare exception and entered that trade on an unhedged basis. This was because we had a strong view that the euro would depreciate against most major currencies last year, including the NZD. That did not occur last year as the euro surged higher, which meant that our New Zealand-Germany trade took losses as NZD/EUR declined. For now, we are keeping that trade on an unhedged basis given the depressed level of NZD/EUR, but we will keep a tight stop going forward in the event of a broader breakdown in the NZD. Bottom Line: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 https://www.reuters.com/article/us-newzealand-economy-finmin/new-zealand-finance-minister-says-new-rbnz-governor-must-take-on-dual-mandate-idUSKBN1DG0EY?il=0 4 https://www.reuters.com/article/us-newzealand-economy-rbnz-orr/rbnz-governor-says-markets-finally-getting-the-hint-on-low-rates-idUSKBN1IC0LS 5 https://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement/mps-may-2018 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns