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Underweight This summer, we downgraded the S&P soft drinks index to underweight based on a collapse in beverage shipments and its high correlation with relative performance. That decline has since accelerated but even lower volumes have not been enough to reverse the industry's price deflation (second panel). Index heavyweights KO & PEP recently reported declining Q3 revenues and profits, confirming the message that demand is shrinking and earnings will continue to suffer. Valuations too have come down, reflecting the industry's woes (third panel). However, they sport a 21% premium to the S&P 500 despite much worse growth prospects (bottom panel). Given these industry dynamics, we think the valuation slide has further to go; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST.
Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Overweight We have recently been highlighting the burgeoning capex upcycle as the key investment theme driving our sector rotation into cyclical stocks over defensives. The investment bank & brokers index in particular thrives when the business sector is moving to expansion mode. Capital formation moves in lockstep with business confidence as firms look to expand balance sheets to meet future capital needs; sentiment has been soaring since the November election and so too have secondary equity issues (second panel). This should mean that relative earnings gains for investment banks should follow sky-high capex expectations, if history repeats (third panel). Stay overweight the S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, SCHW, GS, RJF, MS.
Overweight We upgraded the S&P construction machinery & heavy truck index to overweight earlier this month, based on a fresh capex upcycle fueled by exceptionally positive expectations for global capital outlays, with tentative signs that mining and oil & gas would participate. Caterpillar's earnings results yesterday confirm this thesis, with machine sales to dealers having firmly pulled out of their multiyear contraction on a broad basis and all regions seeing expansion (second panel). The positive data is captured by our construction machinery EPS model, which is pointing to continued earnings gains (third panel), boosted by an export-accommodative U.S. dollar. Despite solid gains yesterday, this earnings momentum is still not fully reflected in valuations which remain well below peak levels (bottom panel). Bottom Line: We think the earnings-led recovery in the S&P construction machinery & heavy truck sub-index still have legs; stay overweight. For more details, please see our Weekly Report from October 2, 2017. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.
Highlights China's ascendancy will increase U.S.-China tensions in the medium and long term; "Xi Jinping Thought" is China's rejection of Soviet-style collapse; Xi's new policies face very few domestic political constraints; Xi is playing down GDP targets and playing up centralization; Tax cuts are still coming to the U.S. Feature Global risk assets continue to rally despite an apparent loss of faith in world leaders. In Spain, the showdown between Catalonia and Madrid is escalating as Spanish lawmakers vote to withdraw aspects of self-rule from the wealthy northeastern province. In the U.K., the Brexit negotiations are floundering, causing the Labour Party to raise the alarm against a "no deal" exit from the European Union. In Brazil, the interim president is under legislative scrutiny for corruption; in South Africa, the ruling party is grasping at government employees' pension funds to keep a struggling state airliner afloat. However, policymakers are not always as incompetent as investors (and the financial media) like to think. In China, President Xi Jinping has turned himself into the highest authority since Mao Zedong and Deng Xiaoping. And the country has sprung back from the 2015-16 deflationary spiral so well that financial authorities are tightening financial controls and contemplating interest rate hikes (Chart 1). In Japan, Prime Minister Shinzo Abe has won a two-thirds supermajority in the House of Representatives for the second time, giving him a mandate to continue his "Abenomics" agenda (Chart 2). With unemployment already exceedingly low at 2.8%, Abe could make history. He could rouse the country out of both its deflationary and pacifist slumber in the face of the historic challenges posed by a rising China and multipolar world. Less grandiose, but still highly market-relevant, the U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to hit President Donald Trump's desk by the end of the first quarter of next year. This development is in marked contrast to informal surveys of investors around the world, including at BCA's annual New York Conference last month. The market has hardly reacted to the positive news (Chart 3). Chart 1Real Deposit Rate Is Negative Chart 2Shinzo Abe Does It Again Chart 3Market Still Doubts Trump In this report, we focus on China and the United States. Our recent assessments of Spain and Japan are on track - the former is an overstated risk, the latter an opportunity now largely priced in.1 It is the "G2" that poses the biggest risk of negative surprises over the next 12 months. First Take On The Party Congress China's nineteenth National Party Congress will conclude just as we go to press. Our assessment of the line-up of the new Politburo and specific changes to the Communist Party's constitution will have to wait for a Special Report next week. We can still draw some preliminary conclusions, however.2 First, Xi Jinping's induction into the Communist Party's constitution, under the slogan "Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era," makes him second only to Chairman Mao as a philosophical guide in the party. This says as much about the spirit of the age as about Xi's (formidable) power. It is an era of "charismatic authority," in which populations are restless and political elites either adopt populist tactics (like Xi), or are populists themselves.3 The Communist Party wanted a new Mao and Xi obliged them. Why is this the case in China? The Communist Party has based its legitimacy on economic growth since Deng Xiaoping came to power in 1978. But economic growth is slowing as a result of irreversible, secular trends. The party needs a new source of legitimacy, and Xi has offered a "synthesis" of Mao and Deng: he promises to preserve the Communist regime above all, yet also to continue Deng's pragmatic use of the market to strengthen the fundamentally socialist economy. Thesis, antithesis, synthesis. Xi's focus remains on power, namely reinforcing China's ruling institutions and asserting its international influence.4 We will take the latter first, as it is the biggest source of change in the world and a key driver of market-relevant geopolitical risk. Multipolarity Chart 4U.S. Decline Vis-à-Vis China The most important takeaway from the party congress is that it perfectly captures our long-term investment theme of global multipolarity. This describes a world run by multiple independent powers as American power declines in relative terms.5 The erosion of U.S. global dominance is most striking in relativity to China (Chart 4).6 Xi has declared that it is time for China to take "center stage" in world affairs. He also modified an earlier goal to say that China will become a "leading global power" by 2050. China is unified under a single leader and a single party, its economy has been robust, and it is therefore feeling confident in its ability to take action in the global arena. The implications are disruptive over the long run: Assertive foreign policy will continue: China will continue with the bolder foreign policy it has demonstrated over the past ten years. China's military expenditures, which are widely believed to be larger than official statistics reveal, will continue to drive regional security dynamics (Chart 5).7 Maritime tensions still matter: China's "core interests" in separatist-prone regions like Tibet and Xinjiang have become more secure, whereas its interests in Taiwan and the South China Sea are less secure because of increasing pushback from the U.S. and its allies. The South China Sea is still a potential flashpoint as it governs the vital supply lines of China's major regional rivals and $4 trillion in trade (Diagram 1).8 Diagram 1The South China Sea: Still A Risk Economic statecraft is the new norm: China is using its economic heft to fill spaces left void by the United States. The U.S. is perceived across the region as relying increasingly on "hard power," ceding ground to China to create "soft power" relationships through trade and investment. Beijing is launching its own system of multilateral trade and finance that could someday operate as a sphere of influence in Asia outside of U.S.-led international norms - such as Xi's "Belt and Road Initiative," which was also enshrined in the Communist Party constitution (Chart 6). Moreover, Beijing is using its growing economic leverage to achieve political goals, having imposed informal sanctions on Japan, both Koreas, Vietnam, Taiwan and others in recent years.9 Chart 5China Raises Asian Security Fears Chart 6China's Belt And Road Club These trends were all reaffirmed at the party congress, confirming our view that U.S.-China frictions are a serious geopolitical risk. Fortunately, neither Xi nor China is a loose cannon. Most of these trends are developing over the long run. With Xi Jinping overseeing an extensive overhaul of the People's Liberation Army, there is less reason to suppose that the PLA will act aggressively independent of civilian leadership (as was a concern under the previous administration). One would also think that a transition across the armed forces is an inopportune time to instigate conflicts. Notably, the Xi administration has also tactically adopted a milder diplomatic approach since President Trump's coming to power with an arsenal of threats aimed at China. This approach is evident with Japan, India, and Southeast Asian neighbors. Trump's perceived belligerence gives China the ability to play a mediating role and promote trade and investment with other powers looking to hedge against the U.S. Finally, Beijing appears to have domestic unrest in check, at least for now. Public security disturbances have been elevated in the wake of the global financial crisis, but have declined since 2011 (Chart 7). This is a positive sign for markets because China will have greater ability to push domestic reforms - and less reason to be aggressive abroad - if unrest is subdued. Official statistics suggest that China spends about as much on public security as national defense, revealing a key vulnerability to the state (Chart 8). Chart 7Domestic Unrest Down, Though Not Out Chart 8Domestic Unrest A Risk To The State Bottom Line: The party congress has highlighted China's rising global influence. This ultimately creates higher geopolitical risk, especially in U.S.-China relations. China also has greater control over domestic factors that could instigate conflicts, at least for the time being. Thus the U.S.'s next moves will be critical. Reform And Opening Up The second major takeaway is that the Xi administration is still officially committed to the reform agenda laid out in the 2012 party congress, the 2013 Third Plenum, and the supply-side structural reforms announced in 2015. Xi's work report calling for "sustained and sound" growth is a nod to the need to reduce capital intensity and systemic risks. He also said that supply-side structural reform would be the "main task" for economic policy for the foreseeable future. His economic reform slogans also made it into the party's constitution. Significantly, there are no more GDP targets beyond 2020. Broadly, we have defined Xi's reform agenda as a combination of centralizing control, improving governance, and streamlining the economy.10 Centralization is not necessarily market-positive, but under the Xi administration it has coincided with efforts to improve governance (fighting corruption, reining in provincial freewheeling, and reducing pollution). This is a sign of growing policy responsiveness to public demands and as such is marginally positive. The clear takeaway from the congress is that the anti-corruption campaign will be institutionalized across the country through new "supervisory commissions." This campaign should improve the legitimacy of the party-state and the implementation of central government policies. We have always been skeptical of progress on structural economic reforms, but the party congress marks a new phase in the political cycle: Xi is in a better position than any Chinese leader since Deng Xiaoping to launch significant reforms. He has increased his political capital massively over the past few years, as illustrated by the dotted line in our "J-Curve of Structural Reform" (Diagram 2). Cyclically, the next opportunity for China to undertake bold reforms may not occur until 2027. Hence it is either now or never for reform. The policy focus is supposed to push along China's economic transition from investment- to consumption-led growth (Chart 9). Importantly, Xi declared that the "principle contradiction" in Chinese society has changed since the 1980s. The principle contradiction used to be that of a poor, economically and technologically "backward" country trying to meet the basic material needs of the population. Now the contradiction is that of an "imbalanced" and under-developed economy trying to provide people with "better lives." These goals can be put into perspective by comparison with South Korea, which reveals both how far China has come and how far it has to go (Chart 10). Xi's statement points to an overall shift in policy toward addressing imbalances and improving quality of life. Diagram 2The J-curve Of Structural Reform Chart 9Changing The Economic Model Chart 10From Basic Needs To 'Better Lives' To put a time frame on many of these reforms, Xi created a new long-term deadline of 2035 to become a fully "modernized" economy, which is smack in the middle of the country's previously declared two "centenary goals" of 2020 (middle income status) and 2050 (global prominence). The interim deadline includes a target for narrowing regional and income disparities. Wealth inequality in China has become extreme and ultimately poses a threat to the regime (Chart 11). Such a goal will require serious redistributionist policies as well as ongoing efforts to build a better social safety net. As expected, Xi reaffirmed China's embrace of globalization, claiming that the door of trade "will only open wider." The financial sector is likely to be at the forefront of any new opening measures - top financial officials claim that a package of reforms is forthcoming. The developed world has begun to doubt China's commitment to financial reform given the closing of the capital account last year and other negative trends, like the persistently low (and falling) share of foreign banks in domestic lending. Only recently have foreign banks begun lending again after withdrawing funds in preceding years (Chart 12). Foreign ownership of domestic equities, which is tightly controlled, has also fallen in importance (Chart 13). Chart 11Inequality: A Liability For The Party Chart 12Banks Shying Away From China Chart 13Foreign Investors Limited In China The centralization of power should speed up policy implementation, but it also raises risks. The important thing is whether we see hard evidence that Xi's "absolute power" is corrupting absolutely. This would present a new structural risk to the Chinese system, even if markets initially cheered. Why? Because an administrative (as opposed to propagandistic) turn in China in favor of a "cult of personality" as opposed to "collective leadership" would increase the odds of policy mistakes, set off factional struggle in the Communist Party, increase policy uncertainty for the foreseeable future, and jeopardize the smooth transition of power in 2022 ... or whenever "Chairman Xi" outwears his welcome. Therefore, the implementation of policy, the grooming of "heirs apparent," the position of the opposing faction in the party, and the upkeep of rules and norms will be important to monitor - not just after the party congress, but over the next five years. Bottom Line: Xi has reaffirmed formal structural economic goals like consumer-led growth and a commitment to globalization and has signaled that more reforms are in the works. Policy implementation will improve. Stay overweight H-shares within EM equities. However, excessive concentration of power in Xi himself is a serious political risk. It is only a positive in the long term if Xi uses his authority to build institutions rather than personalize them. Principal Contradictions China's declared goals are, of course, riddled with contradictions. As expected, Xi has tried to be everything to everyone. This leaves investors with a number of missing pieces to try to fit together. For example, the slogan indicating Xi's governing philosophy is a revision of Deng Xiaoping's market-oriented slogan, "Socialism with Chinese Characteristics" (Table 1). Xi is announcing that China has entered a "New Era" that will redefine Deng's formulation. Thus, by quoting Deng, he is reaffirming China's need to continue reforming and opening up. But by simultaneously qualifying Deng, he is reasserting the primacy of the state.11 Table 1Xi Jinping Thought What matters are the concrete policies China actually enacts. Nowhere are the contradictions clearer than in the party's constant assurances that it will both intensify reforms and keep the economy stable. Beijing continues to stress that it will deleverage the financial sector, restructure industry, eliminate overcapacity, and fight smog, all without any negative impact to growth. Given the sharp deceleration in the growth of China's monetary aggregates, we expect a significant slowdown in the coming year.12 "Reform" will in large part consist of demonstrating a higher-than-usual tolerance for slower growth so as to impose market discipline. Authorities will, as always, inject further stimulus if necessary to avoid a hard landing. A key risk to global markets, as discussed last week, is that fiscal spending may not offset a crunch in credit growth next year, should one occur. This is increasingly the case because the composition of fiscal spending in China is shifting as the country focuses more heavily on social stability and economic transition. Education, social security, worker training and relocation, and other public services are simply not as capital intensive as building railroads, urban infrastructure, and houses (Chart 14). Moreover, a critical test of the reform-stimulus trade-off will be Beijing's tolerance for failing companies. Bankruptcies have risen over the past year in China, which suggests that market forces are being given wider scope and that the central government is laying down the legal framework to make bankruptcy more acceptable (Chart 15), a notable reform. This is a clear sign of "short-term pain, long-term gain," but it remains to be seen how far it will go. Chart 14China's Fiscal Spending Is Becoming Less Capital Intensive Chart 15Creative Destruction At Long Last? It is also unclear whether failures will be allowed among state-owned enterprises (SOEs), which are the least profitable and most indebted Chinese companies. The future of SOE reform is no clearer than before the congress: Xi promised both to restructure the sector and to enlarge and strengthen it. The principle is in alignment with the Jiang Zemin administration's maxim, "grasp the large, let go of the small," and does not mean that reform is doomed. More than a fourth of SOEs are under water and the government is already committed to cutting the number of centrally administered SOEs in half. There are now several pilot projects for allowing partial privatization, or creating state holding companies, that can be rolled out nationally. And there are a range of perfectly un-strategic sectors (retail, chemicals, real estate, electronics, et al) that have substantial state ownership that could be liquidated. Judging by listed Chinese firms, those that are deemed to be strategic will not likely see their state share diluted much beneath 80% of ownership; yet those that are designated for partial privatization and mixed ownership could see the state share dwindle to less than 10% of ownership (Table 2). This implies that sweeping changes could occur if the government prioritized SOE reform. (This is true despite the fact that the state's hand would still be obtrusive overall.) Table 2Plenty Of Room For Privatization Bottom Line: Deleveraging and bankruptcies are a key aspect of reform but pose headwinds to growth. The profile of China's fiscal spending is changing to become less capital intensive, which will mean less stimulus for China's aging industries if reforms are pursued. This underscores a real risk to Chinese growth, capex, and imports, and hence to EM. There is no clarity on SOE reform, but it would have far-reaching consequences if prioritized in Xi's second term, given his soaring political capital. Tax Blues In The USA: Are Tax Cuts Really Coming? On the other side of the Pacific, investors remain highly skeptical that tax reform is on the legislative menu (Chart 16). This is after both houses of Congress passed their version of the budget resolution, containing reconciliation instructions for tax reform. Once the House of Representatives passes the Senate version of the budget resolution - which we assume will be swift - the reconciliation process will kick off.13 The Senate version of the budget resolution instructs the Senate Committee on Finance and the House Ways and Means Committee to limit the increase in the budget deficit to no more than $1.5 trillion through 2027.14 The resolution also instructed the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) to consider "to the greatest extent practicable... the budgetary effects of changes in economic output, employment, capital stock, and other macroeconomic variables resulting from such major legislation." In plain English, this refers to "dynamic scoring," macroeconomic modeling that takes into account the revenue-raising potential of major tax cuts. BCA's Geopolitical Strategy has harped on "dynamic scoring" since last November. The tool is a favorite of Republican legislators when passing tax legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. Democrats banned this practice when they took back the Senate in the Obama years, but the GOP promptly re-authorized it in January 2015. Fast forward a year later and two core conclusions of our November 2016 forecast on tax policy are now coming true.15 First, the tax bill will not be revenue neutral, except in the imagination of macroeconomic modeling pursued by Republican economists. The bill will be mildly stimulative, to the tune of $100-150 billion per year over the next decade. The numbers are modest, but given that the U.S. is close to full employment and wage pressures are certain to build up (Chart 17), any additional tax relief is bound to be stimulative for the economy. Chart 16High-Tax Firms Not Outperforming (Yet) Chart 17Inflation Coming Even Without Tax Cuts Second, Republican legislators are not fiscally conservative. The House budget resolution authorizing a $1.5 billion hole in the budget was passed with 18 Republicans dissenting, but 11 of them were from highly-taxed "blue states." Their contention with the bill was not that it would be profligate, but that it would do away with state and local tax deductions in order to pay for the likely $5-$6 trillion price tag. As such, they voted not to make tax cuts less, but rather more, profligate. Going forward, the real threat to the proposed tax bill is in the Senate, where Republicans hold only a slim 52-48 majority. This threat is a surprise, as 12 months ago the question was how a profligate bill would pass the supposedly conservative House. Three risks lurk in the Senate: Alabama: Judge Roy Moore, a highly conservative candidate for the December 12 special election, is holding onto a relatively slim lead against Democrat Doug Jones. A recent Fox News poll shows the two tied in public opinion. Even if the poll is unreliable, other polls suggest that Jones has narrowed the gap to single digits. This is remarkable because Alabama Republicans have defeated their Democrat opponents by an average of 36% in Senate races over the past decade.16 If Moore were to lose, the Republican majority in the Senate would fall to 51. This would leave room for only one defection in passing legislation. The Corker-Flake-McCain Axis: Senators Bob Corker (R - Tennessee), Jeff Flake (R - Arizona), and John McCain (R - Arizona) have all voted in favor of the Senate budget resolution authorizing reconciliation instructions for tax legislation. On that basis, there should be no problem. However, Corker and Flake have announced their retirement, in our view because they plan to challenge President Trump in the 2020 Republican primary. Furthermore, Corker has said in the past that he would not vote for a tax bill that is not revenue neutral. We think that Corker and Flake will ultimately vote for tax cuts, if only because their chances of successfully challenging Trump in 2020 will be higher if they stick to Republican orthodoxy. However, these three Senators are risks to our view as they have the freedom not to care about the 2018 midterms. God: The death of Massachusetts Senator Ted Kennedy on August 25, 2009 greatly changed the fortunes of President Barack Obama, who at the time was enjoying a 60-seat majority in the Senate.17 Democrats failed to move quickly on the Affordable Care Act, assuming that a Democrat would win the special election in staunchly liberal Massachusetts. (If the parallels with Alabama today seem eerie, it is because they are.) But the January 2010 election cost Democrats the 60th seat in a shocking upset. These things can happen again, especially given that the average age of a senator is 103.18 Any one of these factors could reduce the Republican majority in the Senate to 51, forcing President Trump to rely on vociferous critics McCain and Corker. The latter, by the way, is also a likely 2020 primary challenger against Trump. Could a Democrat come to the president's aid? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska), all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states, while Zell Miller of Georgia effectively ceased to be a Democrat and endorsed President George W. Bush reelection at the 2004 Republican National Convention. Ominously for today's efforts, John McCain voted against both versions. Given that he is unlikely to campaign again due to terminal cancer, and given his vociferous opposition to President Trump, we have to assume that he will vote against the tax bill as well. Which Democrats could potentially cross the aisle with this year's reconciliation bill? Table 3 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Particularly vulnerable are Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin). That makes seven potential votes for the Trump tax cut, plenty of "slack" for the Republicans in Senate to lose one or two votes on the tax bill. Table 32018 Senate Races To Watch As far as the timing of the bill is concerned, we are sticking with our updated view that the end of Q1 2018 is far more likely for passage of tax legislation than the end of 2017. There are simply too many things on the legislative agenda between now and the end of the year, including a potential government shutdown and an immigration fight. Bottom Line: The market remains unconvinced that Republicans can pass tax legislation through Congress. However, the tax process has played out thus far almost exactly as we expected last year (aside from starting later). Republicans have proposed a profligate tax bill and are using dynamic scoring to get it through Congress. Going forward, we think that GOP can afford to lose one or two votes, as it did in 2003 with the highly controversial Bush tax cuts. This is because there are up to seven Democratic Senators who can pick up the slack. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Xi is also overhauling the armed forces to imitate modern American joint operations and combatant commands (as opposed to the army-centric Soviet system). 8 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" March 28, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" July 5, 2017, available at gps.bcaresearch.com. 10 See note 4 above. 11 Whether Xi is mentioned specifically, and described as the founder of a school of "Thought," or a lesser "Theory," or something else, will be a notable watchword. 12 Please see note 2 above, "How To Read Xi Jinping's Party Congress Speech," and BCA Emerging Market Strategy Weekly Report, "China: Deflation Or Inflation?" October 4, 2017, available at ems.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 14 Please see S.Con.Res.25, available at congress.gov. 15 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcareserach.com. 16 Current U.S. Attorney General Jeff Sessions, whose retirement from the Senate has prompted the current special election, ran unopposed in 2014 and garnered 97.25% of the vote! 17 Democrats picked up eight seats in the Senate in the watershed 2008 election, boosting their majority to 57, with two Independents caucusing with the Democrats. Shortly after the election, Pennsylvania Republican Arlen Spector changed parties, giving Democrats the 60-seat, filibuster-proof, majority. 18 It is actually 62, but we wanted to make sure you were still reading. Geopolitical Calendar
Highlights Global "Low-flation" Vs. Oil Reflation: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Fed Tightening Vs. Trump Easing: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018 Strong Growth Vs. Modest Inflation In Europe: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Feature The bull market in global risk assets continued last week, with the S&P 500 hitting yet another all-time record and other major bourses in both Developed Markets and Emerging Markets hitting multi-year highs. This is a sensible reflection of the strength and persistence of the current coordinated global economic upturn, which is boosting corporate profit growth worldwide. At the same time, the health of the current expansion has dampened risk-aversion among investors. This is helping to keep market volatility at depressed levels with only modest changes expected for both inflation and monetary policy. Yet there are storms brewing on the horizon that have the potential to shake up this low-volatility, risk-seeking backdrop. Specifically, a potentially less stable outlook for global inflation, amidst uncertainty over the direction of fiscal policy in the U.S. and monetary policy at the Fed and European Central Bank (ECB), could pose a threat to the current Goldilocks environment for risk assets (Chart of the Week). In this Weekly Report, we discuss some macroeconomic "trade-offs" that investors will have to grapple with over the next 6-12 months, and how to position bond portfolios accordingly. Chart of the WeekMarkets Not Worried About The Fed Or ECB Trade-Off #1: "Low-flation" Vs. Rising Oil Prices Chart 2Global Inflation Pressures Are Slowly Building Realized inflation data across the major developed economies is showing no imminent threat of breaching, or even just reaching, central bank targets. This is occurring despite a robust, coordinated global economic expansion that is generating some of the fastest growth rates seen since the Great Recession. With nearly ¾ of the countries in the OECD now with unemployment rates below the estimates of the full employment NAIRU, subdued inflation readings remain a puzzle for both investors and policymakers (Chart 2). The term "low-flation" has been used to describe this backdrop of inflation rates remaining low seemingly regardless of what is happening with growth. Bond investors have reacted to this by keeping market-based inflation expectations at levels below central bank inflation targets, suggesting a potential problem with the credibility of policymakers. Yet a fresh challenge to the low-flation thesis will soon come from the global oil markets. Last week, our colleagues at BCA Commodity & Energy Strategy upgraded their oil price targets for the fourth quarter of 2017 and all of 2018.1 Their estimates for global oil demand were revised upward based on the improving economic momentum, as evidenced by the IMF recently boosting its own forecasts for world GDP growth to 3.6% for all of 2017 and 3.7% for 2018. Combined with continued discipline on output from the so-called "OPEC 2.0" coalition of Russia & Saudi Arabia - currently responsible for 22% of the world's oil production - the global oil market is expected to see demand exceeding supply until late 2018 (Chart 3). The positive demand/supply balance should lead the Brent oil price benchmark to average just over $65/bbl in 2018 (Table 1), which would be a 13% increase from current levels. This is a move that global bond markets are likely to notice, given the strong correlation that still exists between market-based inflation expectations and oil prices in the developed economies. Chart 3A Positive Fundamental Backdrop For Oil Table 1Upgrading The BCA Oil Price Forecasts In Charts 4 & 5, we show the market-based pricing on inflation expectations at the 10-year maturity for the U.S. (using TIPS breakevens), the U.K., Germany, Japan, Canada and Australia (using CPI swaps). For each country, we also show the Brent oil price denominated in local currency terms. We add one additional data point to the charts, shown as an asterisk, incorporating the 2018 average Brent oil price expectation converted at current exchange rates versus the U.S. dollar. As can be seen, the higher oil price that our commodity strategists are expecting should act to put upward pressure on the inflation expectations component of government bond yields in the major developed markets. Chart 4Upward Pressure On Inflation Expectations ... Chart 5... From Higher Oil Prices In 2018 Of course, the unchanged currency assumption made in Charts 4 & 5 is unrealistic. Yet given the significant increase in oil prices that we are expecting next year (+13%), it is also unrealistic to expect enough currency appreciation in any country to fully offset the inflationary impact from oil. In fact, given the BCA view that the U.S. dollar should enjoy one last cyclical boost next year as the Fed delivers more rate hikes than the market is currently discounting, inflation expectations may actually rise by more than we are showing in our charts in non-U.S. countries (given that oil is priced in U.S. dollars). In Table 2, we show the forecast for the local-currency Brent oil price for 2018 and the date that oil prices were last at that level in each country (all in 2015 after the cyclical peak in oil prices that began in 2014). We also present the data on 10-year government bond yields, the 2-year/10-year slope of yield curves, market-based inflation expectations, and realized headline and core inflation rates for the major developed economies. We show the current levels for all those variables, plus the levels that prevailed the last time oil was at the levels we are forecasting. The major differences that stand out are: Table 2Bond Markets Now Vs. The Last Time Oil Prices Were In The Mid-$60s Yield levels are not dramatically different than where they were in 2015 in the U.S., Canada and Australia, but are lower now in the U.K., Euro Area and Japan thanks to central bank asset purchase programs. Yield curves are much flatter now in the U.S., U.K., Canada and Japan, but are steeper in the Euro Area and Australia. Market-based inflation expectations now are very close to the levels that prevailed in 2015, except in Japan where they are much lower. Headline inflation rates are much higher now everywhere except Australia, while core inflation rates are a lot higher in the U.K., a touch higher in the U.S. and Euro Area, and lower everywhere else. The conclusion from Table 2 is that there is potential for bond yields to rise as oil prices head higher in the U.S., U.K. and Euro Area given that inflation expectations are at the same levels as 2015 but realized inflation rates are higher. This would suggest that owning inflation protection in these countries is a sensible way to play the "low-flation vs. oil reflation" trade-off - trades that we already have in place in our Tactical Trade Overlay by being long Euro Area CPI swaps and owning U.S. TIPS versus nominal U.S. Treasuries and (see table on page 16). We are reluctant to add U.K. inflation protection to this list, however, and may even look to go the other way given the likelihood that the currency-fueled surge in U.K. inflation is in the process of peaking out. In sum, bond markets will be unable to ignore a combination of strong global growth (still called for by rising global leading economic indicators), tightening labor markets and rising oil prices in 2018. As investors come to grips with oil trading with a 60-handle for the first time since 2015, inflation expectations should widen out in all developed market countries that are at, or beyond, full employment. This should put upward pressure on nominal bond yields as well, and potentially trigger bear-steepening of yield curves if central banks do not respond to higher oil-driven inflation with a faster tightening of monetary policy. Bottom Line: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Trade-Off #2: Fed Tightening Vs. Trump Easing Last Friday, the U.S. Senate passed President Trump's budget plan by the slimmest of margins (51 to 49), allowing for an increase in federal deficits of up to $1.5 trillion over the next decade. Trump immediately put pressure on the U.S. House of Representatives to also pass the Senate plan, and the initial comments from House Republican leadership was that they would also endorse the Senate budget proposal which included significant tax cuts for corporations and some households. This is unsurprising given that the Republicans need a major, economy-boosting legislative victory to present to voters in next year's U.S. Midterm elections. The U.S. Treasury market responded to this news on Friday in a fashion that we believe to be sensible - the curve bear-steepened, with the 2-year/30-year spread widening 4bps on the day. We have written about the interaction between budget deficits, Fed policy and the slope of the Treasury curve in past Weekly Reports this year, most recently at the beginning of this month.2 Chart 6 is taken from that most recent report, and we feel that it is important to go through our logic once again after last week's events. Chart 6UST Curve: Bear-Steepener First, Bear-Flattener Later The Treasury curve typically steepens during periods when the U.S. federal budget deficit is widening (top panel). The Treasury curve is typically negatively correlated to the real fed funds rate, steepening when the real rate is falling and vice versa. Budget deficits usually are widening during periods of soft economic growth, when tax receipts are slowing and counter-cyclical fiscal spending is increasing. This is also typically correlated to periods when spare capacity in the U.S. economy is opening up and inflation pressures are diminishing (middle panel), hence giving the Fed cover to lower interest rates and putting steepening pressure on the Treasury curve. The current backdrop is atypical, as a fiscal stimulus is being proposed at a time when the economy is already at full employment with little sign of slowing. At the same time, the Fed is in a tightening cycle - albeit a slow one because of relatively subdued inflation - which usually does not occur during periods of widening budget deficits. This represents another difficult "trade-off" for investors to process. A so-called "full employment" fiscal stimulus should be inflationary at the margin, by definition, if it boosts economic growth to an above-potential pace. That would steepen the Treasury curve as longer-term inflation expectations rise, until the Fed steps in with rate hikes to offset the impact of the fiscal stimulus. If the Fed felt that the greater fiscal deficit was becoming a problem for medium-term inflation stability, then there could be a faster pace of rate hikes that would boost the real funds rate and put flattening pressure on the Treasury curve. A more straightforward way to describe that would be a scenario where the Trump tax cuts end up boosting U.S. real GDP growth to something close to 3% next year, which results in the U.S. unemployment rate falling to a "3-handle". This would likely put upward pressure on U.S. realized inflation and steepen the Treasury curve as the market prices in higher inflation - IF the Fed is slow to respond to that inflation pickup. When inflation rises by enough to threaten the Fed's 2% inflation target, perhaps even rising above that level, then the Fed would step in with more rate hikes. The result: a higher real fed funds rate and a flatter Treasury curve. That scenario is how we envision the next year playing out. Various FOMC members have already noted that they cannot account for any fiscal stimulus in their economic projections until they see the details. Furthermore, many members of the FOMC are expressing concern that the downdraft in inflation was enough of a surprise to raise questions about the Fed's understanding of the underlying inflation process. This suggests that the Fed will want to see inflation, both realized and expected, rise first before increasing the pace of rate hikes beyond current projections. Net-net, we see the Trump fiscal stimulus steepening the Treasury curve in 2018 before the Fed flattens it with tighter monetary policy. One caveat for the latter is the upcoming decision on the next Fed Chair. President Trump, ever the reality game show host, noted last week that the finalists for this season's episode for "The Apprentice: FOMC" are now down to Jerome Powell, John Taylor and current Chair Janet Yellen. Both Powell and, of course, Yellen would represent a continuation of the current cautious FOMC framework, while Taylor would likely be more hawkish given his public comments on Fed policy decisions (and the output of his own Taylor Rule!). If Taylor were to be appointed by Trump as the new Fed Chair, the Treasury curve may not steepen much on the back of fiscal easing if the markets begin to discount a more aggressive Fed. Bottom Line: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018. Trade-Off #3: Strong European Growth Vs. Mild Inflation The ECB meets later this week, and is expected to make a decision on the size and scope of its asset purchase program for next year and beyond. The latest Bloomberg survey of economists is calling for a cut in the monthly pace of asset purchases from €60bn/month to €30bn/month, but with an extension of the program until September 2018.3 The same survey calls for the ECB to deliver a hike in the deposit rate in Q1/2019, with a hike in the benchmark interest rate in Q2/2019. We agree with the former, although we think there will be no rate hikes of any kind until the 4th quarter of 2019, at the earliest. Chart 7Why Would The ECB NOT Taper? The trade-off between robust European growth and still modest rates of core inflation are the reason we expect the ECB to be very late to begin hiking policy rates after the asset purchase program is completed. It is clear from a variety of data, from almost all countries in the Euro Area, that the economy is expanding at a robust, above-potential pace (Chart 7). Headline inflation has increased steadily off the 2015 lows and now sits at 1.5%, still below the ECB's target of "just below 2%". The ECB has played down this pickup in inflation, given that is has largely been driven by the rise in oil prices since the 2015 lows. There is certainly a strong correlation between the annual change of oil prices (denominated in euros) and Euro Area headline inflation (middle panel), and the ECB expects fading oil price momentum to result in Euro Area headline inflation drifting back to 1% in early 2018. Yet the oil price increase that our commodity strategists are calling for next year would boost the year-over-year growth rate to a pace around 40%, which has in the past been consistent with 2% headline inflation outcomes. A rising euro would help mitigate the impact from oil, but as mentioned earlier, we see more potential for some modest depreciation of the euro versus the U.S. dollar after the run-up seen in 2017. Despite the pickup in headline inflation already underway, core inflation in Europe remains benign at 1.1%. Our measure of the "breadth" of the rise in core inflation across 75 individual subsectors - the Euro Area core inflation diffusion index - sits right around the "50 line" suggesting that just as many components of Euro Area core inflation are rising as are falling. Yet with broad Euro Area unemployment approaching 8%, and with some measures of wage inflation starting to awake as a result, the odds are increasing that continued strong growth will result in additional upward momentum in core inflation. The ECB is already forecasting a return of core inflation to 1.9% in 2019, which is why some reduction in the pace of asset purchases will be announced this week. The entire asset purchase program was only put in place in 2015 to fight a deflation threat after oil prices collapsed in 2014, and that has now passed with inflation steadily grinding higher. So the "trade-off" for investors in Europe, between strong growth and moderate inflation, will be resolved by the ECB shifting to a less-accommodative monetary policy stance. In terms of the impact on Euro Area bond yields, however, the change in the pace of bond buying matters even more than the size of the asset purchases. In Chart 8, we show the ECB's monetary base and three scenarios for how it will evolve through asset purchases until the end of 2018: Base Case: The ECB slows the pace of bond buying to €30bn/month starting in January 2018 until September 2018, then cuts that down to €15bn/month for the remainder of 2018 and stops the program completely at year-end. Dovish Scenario: The pace of bond buying is maintained at €60bn/month until the end of 2018, with no commitment to end the program then. Hawkish Scenario: The ECB tapers its purchases by €10bn/month for the first six months of next year, then ends the program in July 2018. In the bottom two panels of Chart 8, we show the year-over-year growth rate of the ECB's balance sheet, with those three scenarios, and compare them to the benchmark 10-year German Bund yield and our estimate of the German term premium. In all three scenarios, even the dovish one where the ECB keeps on buying at the current pace, the growth rate of the monetary base will decelerate in 2018. As can be seen in the chart, that growth rate has been highly correlated to yields and the term premium during the life of the ECB's asset purchase program. The conclusion here is that central bank asset purchase programs need to increase in size versus previous years to maintain the same impact on bond yields over time. Put another way, asset purchases represent a signaling mechanism ("forward guidance") from a central bank to the markets about future changes in interest rates when they are already at the zero bound. Increasing the size of the purchases sends a more powerful message than simply keeping the pace of buying unchanged. This is especially true if the underlying economy is growing and inflation is rising, which would typically cause investors to price in a higher expected path of interest rates into the government bond yield curve. So, unless the ECB takes the highly unlikely step of increasing the size of its asset purchases for next year, then there are no outcomes from this week's ECB meeting that should be expected to be sustainably bullish for longer-dated European government bonds. At the same time, there will be no signals given on future changes in short-term interest rates, as the ECB has maintained for some time that rates will not be touched until "some time" after the asset purchase program has ended (Q4/2019, in our view). Hence, Euro Area yield curves are likely to eventually see some bear-steepening pressure on the back of this week's ECB meeting. The story is similar for Peripheral European government bonds and Euro Area investment grade corporate credit. In Chart 9, we show the same growth rates of the ECB monetary base with our scenario projections versus the 10-year Italy-Germany spread, 10-year Spain-Germany spread, 10-year Portugal-Germany spread and the Barclays Bloomberg Euro Area Investment Grade corporate spread. While the correlations are not as clear as that for German yields, a slower pace of ECB asset purchases would be consistent with some spread widening in Peripheral European and in corporate credit. Chart 8ECB Bond Buying:##BR##Watch The Pace, Not The Level Chart 9European Credit Spreads##BR##Set To Widen Post-ECB? Bottom Line: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19th 2017, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "The Case For Steeper Yield Curves", dated October 3rd 2017, available at gfis.bcaresearch.com. 3 https://www.bloomberg.com/news/articles/2017-10-22/draghi-seen-going-for-ecb-bond-buying-limit-in-qe-s-last-hurrah The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Overweight We remain constructive on the S&P banks index as all three key drivers of bank profits, namely loan growth, price of credit and credit quality, are simultaneously moving in the right direction. Leading indicators of loan demand are accelerating; consumer confidence is exceptionally strong and the ISM manufacturing survey has been on fire lately (second panel). On the price of credit front, if BCA's bond view pans out in the next year and the 10-year Treasury yield veers closer to 2.8-3% range with rising inflation expectations in the driver's seat (third panel), then bank profits should continue to accelerate. Finally, credit quality remains pristine; loan loss reserves have recently crossed above non-current loans in Q2 according to the FDIC, for the first time since 2007. Historically, a rising reserve coverage ratio has been synonymous with increasing valuations and the current message is that the banks rerating phase is in the early innings. Bottom Line: We reiterate our early-May overweight stance in the S&P financials sector and continue to overweight the heavyweight S&P banks sub-index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.