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Highlights Portfolio Strategy Bank profits are unlikely to match those of the broad market if the Fed hikes interest rates and loan demand cools. Sell into strength. Gold shares are looking increasingly attractive, but we will refrain from upgrading until the U.S. dollar is closer to a peak. Drug pricing power is worse than government data suggests, warranting a downshift in our previously upbeat view toward pharmaceutical equities. Recent Changes S&P Health Care - Removed from our high conviction list. Upgrade Alert Gold Shares - Currently neutral. Downgrade Alert S&P Pharmaceuticals Index - Currently overweight. S&P Biotech Index - Currently overweight. Table 1 Feature Chart 1From Greed To Fear The gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. Indeed, investors have been scrambling to buy protection, aggressively bidding up near-term VIX contracts, especially relative to longer-term contracts. While it is tempting to view this increase in fear as a contrary positive, this measure typically sinks lower when investors turn cautious. Chart 1 shows that tactical broad market vulnerability still exists. On a more fundamental basis, the non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years (Chart 2). Yet the median price/sales and price/earnings ratios are flirting with all-time highs (Chart 2). That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap. Third quarter earnings have failed to impress thus far, keeping the equity market locked in a tight range. So far, one nascent trend is that domestic and consumer-linked equities appear to be gaining traction at the expense of global, business-dependent sectors. We expect the complexion of earnings contributions to become more lopsided in the quarters ahead, in support of most of these budding trend changes. The inevitable upshot of a strong U.S. dollar is deteriorating profit breadth. Chart 3 shows that the number of industry groups experiencing rising forward earnings estimates is likely to erode as the currency strengthens. Clearly, industries most reliant on exports and/or capital spending are most vulnerable. The corporate sector has run up debt levels and is struggling to generate profit growth. In turn, business spending has been compromised, as measured by the contraction in core durable goods orders (Chart 3). On the flipside, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salary growth is underpinning real median household income. The latter surged 5.2%, posting the largest percentage increase in the history of the data. Consumer income expectations are well supported (Chart 3, top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance, even if the labor market slows. From an investment theme perspective, the upshot is domestic-oriented areas are poised to make a comeback relative to globally-exposed sectors after a burst of speed in recent months (Chart 4). Net earnings revisions are already shifting in that direction, with more upside ahead based on U.S. dollar strength, as well as dirt cheap relative valuations (Chart 4). Chart 2A Disturbing Mismatch Chart 3Consumers Are Stronger Than Corporates Chart 4Favor Domestic Vs. Global One exception is the banking sector, where there is limited scope for earnings outperformance and/or valuation expansion. Bank Stocks Are Showing Signs Of Life, But... Bank stocks have moved higher, following the sell-off in global bond markets and steepening in yield curves sparked initially by the Bank of Japan's curve targeting shift and a reversal of incremental easing expectations from the Bank of England. However, we are not convinced that the relative performance bear market is over. A Special Report published on October 3 surveyed the performance of banks during Fed tightening cycles, to help put context around the widely held view that Fed rate hikes will bolster bank stocks on a sustained basis. History shows there has been only a loose relationship between the Fed funds rate and net interest margins. It would take rising rate expectations within the context of a steeper yield curve, improving credit quality and rapid loan growth to justify an optimistic profit outlook. Bank profits have not been able to outpace the broad corporate sector since the beginning of 2015 (Chart 5, top panel), even though loan growth has been healthy and overall earnings were crushed by the implosion in commodity prices during that period, allowing most other sectors to show earnings outperformance. Will another 25 bps interest rate hike remedy this? The Fed is keen to hike rates partially because it views them as being overly accommodative for an economy operating close to full employment, and is keen to reestablish firepower in advance of the next economic downturn. But there is scant evidence of economic overheating to support the view that rates have been 'too low'. Inflation and inflation expectations, while up from very depressed levels, are still historically low and the economy is struggling to grow at, let alone above, trend. Consequently, a strident Fed would boost the odds of a policy mistake. The market appears to share that view, given the failure of the yield curve to stop narrowing since the taper talk started, notwithstanding the recent blip up (Chart 5, bottom panel). Chart 5Why Would Bank Profits Outperform Now? Chart 6Beware U.S. Dollar Strength Now that the USD is strengthening anew, the odds of imported deflation have climbed, to the detriment of corporate profits and bank stock relative performance (Chart 6, top panel). While nominal yields have backed up, real 2-year yields have declined, which is not consistent with an upgrading in economic expectations. Indeed, C&I loan growth has dropped sharply in recent weeks (Chart 6). By extension, it is hard to envision long-term yields rising much, if at all, which will keep net interest margins thin. Furthermore, if overall earnings remain stuck in neutral, corporate credit quality will undoubtedly worsen given the debt binge in recent years. Non-performing loans have only just begun to increase. Higher interest rates will not solve these problems. Instead, the downturn in credit quality could accelerate via more onerous debt servicing requirements, given the lack of a corporate sector balance sheet cushion. Perhaps more worrying is that banks are no longer pruning cost structures, which is unusual given that credit standards are tightening on most credit products outside of traditional mortgages. In the last 25 years, or as far back as we have the data, bank stocks lagged the broad market after bank employment started rising. The only exception was in the aftermath of the tech bubble, when all non-TMT sectors outperformed (Chart 7). If banks continue to expand their wage bill, without a widening in net interest margins and/or reversal in increased loan loss reserving, bank profits will fail to match the growth rate of the overall S&P 500. The optimal, but not exclusive, time for banks to outperform is typically exiting recession, when policy is easing and the yield curve is steepening, and in the late innings of an expansion. In fact, productivity is sagging throughout the financial sector. Financial sector employment is probing new highs (Chart 8), reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales, a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. Chart 7Beware Rising Bank Employment Chart 8Sectoral Productivity Drain Bottom Line: Strength in bank stocks is a chance to sell. Is It Time To Buy Back Gold Shares? Gold shares are bouncing after having been punished in the last few months. Overheated technical conditions and prospects for a more hawkish Fed led us to recommend taking profits in August, despite a positive long-term outlook. Indeed, the likelihood of a prolonged period of negative to ultra-low real interest rates is high given startlingly low potential GDP growth in most of the developed world. Gold shares typically do well in the aftermath of a debt binge, as proxied by our Corporate Health Monitor (CHM, shown advanced, Chart 9). It is unnerving that the CHM has suffered such a broad-based deterioration without any back up in interest rates. Low interest rates and tight credit spreads have cushioned what has otherwise been a stark erosion in debt servicing capabilities: there is little scope for a parallel upshift in the global interest rate structure. These are bullish conditions for gold shares, as captured by the upbeat reading in our Cyclical Gold Indicator (Chart 9, top panel). As such, when we took profits we advised that we would look to return to an overweight position once tactical downside risks had been reduced. Are we there yet? Chart 10 suggests that extreme bullishness toward the yellow metal has not yet fully unwound. While the share price ratio has dropped back to its 200-day moving average, cyclical momentum remains elevated, as measured by the 52-week rate of change. Sentiment in the commodity pits is still elevated, flows into gold ETFs are still strong and net speculative positions have not yet made a full retreat (Chart 10), especially in view of the recent politically-motivated pop in market volatility. The implication is that there could be additional selling pressure in the coming weeks. Chart 9Cyclically Appealing, But... Chart 10... Still Tactically Frothy Chart 11The Currency Is Critical In terms of potential buy triggers, anything that causes the U.S. dollar to lose its bid is a strong candidate. Ironically, a Fed rate hike could produce such an outcome, contrary to popular wisdom. In our view, the U.S. (and global) economy cannot handle tighter financial conditions, and a rise in interest rates would need to be offset by a weaker currency. Gold shares perform well when economic expectations are faltering (Chart 11, shown inverted), and a hawkish Fed would likely raise global economic fears. On the flipside, a go-slow Fed could keep the currency bid. That would allow the economy more time to heal and recover, and possibly overheat, thereby potentially boosting future returns on capital, certainly relative to other countries where output gaps remain larger. Bottom Line: Stay neutral on gold stocks, but put them on upgrade alert in recognition that an upgrade back to overweight could occur sooner rather than later, i.e. by yearend, depending on macro dynamics. What To Do With Drug Stocks? A number of drug wholesalers reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has not been confirmed by neither strong retail drug store sales nor booming hospital employment (Chart 12). Nor is there an unwanted inventory build (Chart 12). Nevertheless, in light of new information, which implies that company-reported pricing pressure is worse than current government data shows, we are downgrading our outlook for drug-related shares. Still, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels (Chart 12), we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. Keep in mind that the drug price increases are still well in excess of the overall rate of inflation as branded drug prices continue to rise (Chart 13), and earnings stability should be increasingly desirable as the U.S. dollar climbs. In the meantime, drug-related shares are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit if drug inflation cools. For instance, a reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent (Chart 14), underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Chart 12Under The Gun... Chart 13... But Pricing Power Remains Strong Chart 14Celebrating Reduced Cost Inflation Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions (Chart 14), suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: The pain in drug-related shares should provide a gain to health care insurers. Stay overweight the S&P managed care index. However, look to lighten the S&P pharmaceutical and biotech indexes on a relative performance bounce in the coming weeks, both are now on downgrade alert. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components Chart 5Protector Portfolio Returns In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady Chart 9Wage Growth Is Perking Up To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html
Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar Chart I-5Lower Impact Of Manufacturing ##br##And Commodities Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion Chart I-9China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The relative performance of media stocks over the past few months would seem to foretell of a downturn in cash flow prospects. However, the opposite is true. The latest consumer spending data showed that outlays on media products and services are accelerating, both in absolute terms and relative to total consumption. In turn, that is driving up media pricing power, to growth rates not seen in more than a decade. Media pricing power often leads relative sales growth expectations, pointing to a re-rating ahead. Importantly, media productivity is also on the upswing, as proxied by sales-to-employment, which leads momentum in relative forward profit estimates. The implication is that the budding recovery in the share price ratio is likely to gain traction. Stay overweight.
Financial stocks have risen in sympathy with the back up in global bond yields, but that likely represents position squaring more so than a sustained shift into the sector. Financial profits will continue to be challenged by a downturn in the credit cycle, both in terms of quality and loan creation, given the negative global credit impulse and flattening yield curve (shown inverted and advanced, bottom panel). Importantly, productivity is waning. Financial sector employment is probing new highs, reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales (third panel), a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. We continue to view cheap financial sector valuations as a trap, and recommend below benchmark positions.
A reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent, underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions, suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: the pain in drug-related shares should provide a gain to health care insurers. Stay overweight.
A number of drug wholesalers have reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic drug pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has neither been confirmed by still strong retail drug store sales nor booming hospital employment. Nevertheless, in light of new information, which implies that company disclosed pricing pressure is worse than current government data show, we are downgrading our outlook for drug-related shares. However, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels, we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. In the meantime, the S&P pharma and biotech indexes are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit, see the next Insight.
Highlights U.S. Corporates: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay defensive in Euro Area corporates, favoring Investment Grade over High-Yield. Feature Better Global Growth Not Necessarily Better For Corporate Bonds Back in July of this year, BCA put its flag in the ground and called an end to the 35-year global bond bull market after government bond yields hit historic lows following the shocking U.K. Brexit vote.1 Yields have steadily crept up since we made that declaration, due to a combination of changing cyclical factors (improving global growth, modest increases in inflation), some signs of diminished political concerns (no immediate global spillovers from a more drawn-out Brexit process, the fall in the odds of victory of the "anti-status-quo" candidate in the U.S. presidential election, Donald Trump) and structural factors (worries about less accommodative monetary policies, a political shift towards greater deficit-financed government spending). While government bond yields have been rising from depressed levels, corporate bond returns on either side of the Atlantic Ocean have at the same time lost considerable momentum, both in absolute terms and relative to sovereign debt (Chart of the Week). This is a bit of a surprise given the recent improvement in global growth data that is now appearing in a broadening number of countries (Chart 2), which would suggest a potential brighter outlook for corporate earnings. However, credit valuations and the liquidity backdrop matter, and a potential cyclical improvement in profits may not benefit corporate bond performance at a time of tight spreads and greater uncertainty about future central bank policies. Chart of the WeekIs The Party Ending For Corporate Bonds? Chart 2A Broadening Pickup In Global Growth With credit spreads currently priced for a near-perfect backdrop of low volatility and highly accommodative central banks, we continue to recommend an overall defensive posture in "Trans-Atlantic" corporate bonds, favoring Investment Grade (IG) over High-Yield (HY) in both the U.S. and Euro Area. Chart 3U.S. Corps Are Now ONLY A 'Tina' Trade U.S. Corporates: Stretched Valuations, Especially For Junk Bonds U.S. corporate bonds have been one of the biggest beneficiaries of the so-called "TINA" (There Is No Alternative) trade, where investors have been forced into riskier assets out of low-yielding government bonds. The return performance for both investment grade (IG) and high-yield (HY) debt has been outstanding, with the former up 8.2% year-to-date and the latter up +15.9%. The fundamental backdrop for corporate debt, however, has shown few signs of any improvement that would justify such strong returns, according to our U.S. Corporate Bond Checklist (Chart 3): 1.Corporate balance sheets are deteriorating: Our U.S. Corporate Health Monitor (CHM), an amalgamation of various bottom-up credit metrics applied to top-down corporate profit data, continues to signal that balance sheets are worsening. This trend has been ongoing for more than two years and shows no signs of slowing, with companies continuing to ramp up leverage to record highs at a time of increasing downward pressure on profit margins. 2.Bank lending standards are slowly tightening: The U.S. Federal Reserve's Senior Bank Loan Officer Survey has begun to flash that a greater number of U.S. banks are tightening lending standards on commercial & industrial loans. The net number is still low within the history of this series, and is largely the result of tightening standards on domestic energy companies suffering from the lower oil prices of the past two years. Nonetheless, the highly cyclical nature of lending standards suggests that a move back to easier standards may not happen at this advanced stage of the multi-year credit cycle. 3.Monetary conditions are tighter, but remain stimulative: Our U.S. Monetary Conditions Index (MCI), which is a weighted combination of short-term interest rates and the U.S. dollar, remains at an accommodative level, even after the 18% rise in the trade-weighted dollar since the trough in 2014 and the Fed's lone rate hike last year.2 Interest rates are far more important in our MCI calculation than the dollar (by a 10/1 ratio), however, so it would take an exceptionally large move in the dollar to push the MCI to restrictive territory after just a single 25bp rate hike. Yet with the Fed clearly in a slow hiking cycle that could deliver at least another 75bps of rate hikes by the end of 2017, the MCI will continue in a tightening direction that has historically been correlated with wider corporate bond spreads. With only an easy money backdrop supportive of narrower credit spreads, there is a growing risk that U.S. corporates could respond poorly to a December Fed rate hike that we expect - especially if that also coincides with renewed strength in the U.S. dollar. Already, the Fed's trade-weighted dollar index has risen by 3.2% during the recent Treasury market selloff, as the market-determined probability of a December hike has risen to 66%. This remains below the peaks seen in the run-up to the rate hike at the end of 2015, which coincided with a big widening of corporate credit spreads (Chart 4). One major difference from a year ago is that the Fed is not signaling the same degree of monetary tightening after the next hike. The FOMC median interest rate projections (the "dots") were indicating another 100bps of hikes following the December 2015 rate increase, and are now only signaling another 50bps of hikes after the Fed's expected next move in December. This is keeping both the 2-year Treasury yield and the dollar well below the peaks seen at the end of last year, helping prevent a breakout in market volatility and credit spreads. So if there is a fresh spike in volatility and/or the dollar, it would be striking the corporate credit markets at a time when valuations look stretched. We can see that in a number of indicators. U.S. corporate bond excess returns have far exceeded the levels suggested by domestic capacity utilization, which are relevant for corporates given their long-standing correlation to profit margins (Chart 5). Our colleagues at our sister publication, U.S. Bond Strategy, have calculated that a 0.4% improvement in capacity utilization has historically coincided with a 100bps tightening in HY bond spreads over a 1-year period; thus, utilization would have to rise to 77.2% by next February (a level last seen in March 2015 when the annual growth rate of Industrial Production was 2.5 percentage points faster than the current pace) to justify HY spreads at current levels.3 In other words, junk bonds are already priced for a significant recovery in U.S. economic growth and corporate profits. Chart 4U.S. Corps Not Responding To A Rising USD...Yet Chart 5Ignoring The Signal From Capacity Utilization U.S. corporate bond excess returns over duration-matched Treasuries during the past twelve months have been strongly positive: +316bps for IG and +844bps for HY. Our past work analyzing U.S. credit cycles has shown that such a positive return performance usually occurs during the deleveraging stage of the corporate credit cycle, typically during recessions when profits are falling and growth in company debt stalls or even contracts (Charts 6 & 7). Chart 6Investment Grade Corporate Annual Excess Return* Chart 7High-Yield Annual Excess Return* Chart 8Spreads Ignoring The Usual Credit Cycle The current environment is one of declining corporate profits but with debt growth still expanding, similar to the credit spread widening backdrop around the 2000 and 2008 U.S. recessions (Chart 8). This sends a similar message to the relationship of credit returns with capacity utilization, with corporate bonds now priced for a strong rebound in profit growth that may be difficult to achieve over the next year. A similar situation exists in the equity market, where the consensus bottom-up expectation is for overall profit growth to surge to +13% in 2017 and +11% in 2018.4 That would represent a sharp rebound from the profit declines witnessed in 2015 and the first half of 2016. Chart 9A Stretched Rally In U.S. Junk Some may argue that such a significant rebound in overall corporate earnings could happen just from the impact of better outlook for profits in the Energy sector given the recent recovery in oil prices. However, it appears that U.S. corporate bond valuations already more than fully discount a higher crude price. The 2016 rally in U.S. junk bonds has been led by the massive tightening of spreads of oil-related names, with the benchmark Bloomberg Barclays High-Yield Energy index returning 33% year-to-date as spreads have collapsed. However, the current Energy index OAS is at 550bps - levels last seen during the 2015 counter-trend rally in oil prices after the 2014 plunge (Chart 9, middle panel) That rally took the Brent crude price of oil up to $67/bbl, well above the current price hovering around $50/bbl. Our Commodity strategists continue to see $60/bbl as being the ceiling for the oil price range over the next year, as prices above that would begin to draw supply back into the market from U.S. shale companies and other global oil producers with higher break-even prices. Thus, U.S. HY energy debt already discounts an oil price that is unlikely to be achieved in the medium-term. A similar situation exists when looking at non-Energy junk spreads, which are highly correlated with macro volatility measures like the VIX index and which already fully reflect the current low volatility backdrop (Chart 9, bottom panel). We are concerned about a pick-up in volatility in the near-term from either a political surprise like a Trump victory on November 8 or, more likely, market jitters when the Fed delivers on a rate hike in December. With our fundamental VIX model, which is based off the lagged impact of rising corporate leverage and tightening monetary conditions, continuing to signal that the fair value level of the VIX is around 20, credit markets are not prepared for a potential rise in volatility in the next few months. Challenging Valuations At All Levels When we look at our various valuation gauges for U.S. corporate debt, it is difficult to find many areas where credit looks cheap. With regards to IG debt, our preferred measure of valuation is the 6-month breakeven spread, which shows how much spreads would need to widen to full offset the carry advantage of owning IG debt over duration-matched U.S. Treasuries, assuming spread volatility is maintained at recent levels. That breakeven spread now sits at a mere 9bps (Chart 10, top panel), well below the long-run mean. In other words, IG excess returns can easily turn negative with only a modest widening of spreads. For HY debt, our preferred valuation metric is the default-adjusted spread, where we subtract expected default losses estimated by our default rate and recovery rate models from the current junk spread. That adjusted spread is now only 69bps - a level more than one standard deviation below the long-run mean that we consider to be overvalued (bottom panel). With spreads at such depressed levels relative to expected default losses, the historical probability of junk delivering positive excess returns over the next year is extremely low. We see a similar stretched valuation backdrop when looking at credit spreads among sectors and ratings cohorts. Within the IG universe, the OAS for Financials, Industrials and Utilities have fully converged (Chart 11, top panel), while credit spread curves are near the tranquil 2005-2007 period of historically low volatility that we do not expect to be repeated (bottom panel). Within sectors, our U.S. IG relative value model only sees attractive spreads in the debt of Banks, Energy, Metals & Mining, Building Materials, Technology and Airlines. Chart 10Expensive Valuations, Especially For Junk Chart 11Not Much Difference To Choose From Here Bottom Line: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and corporate profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: ECB Buying Keeping IG Rich While Junk Fundamentals Worsen Turning towards Europe, a similar story of expensive corporate credit valuations exists, although not to the same magnitude as in the U.S. Of course, valuations may not matter for Euro Area IG with the European Central Bank (ECB) buying corporate debt as part of their quantitative easing (QE) asset purchase program. That surge in QE buying (both real and anticipated by investors) helped drive both yields and spreads for Euro Area IG sharply lower between March and June of this year. Since then, however, both yields and spreads have gone up moderately (Chart 12), reflecting both the rising global yield backdrop and the worsening situation for Euro Area banks whose debt dominates the IG market. Chart 12Euro Area Corporate Bond Rally Has Stalled Chart 13Euro Area Valuations Are Not That Cheap The rise in Euro Area corporate credit spreads comes at a time when investors have grown increasingly concerned about a potential tapering of the ECB's QE when the current program expires in March of next year. As we discussed in our previous Weekly Report, we expect the ECB to announce in December an extension of the government bond QE to at least September 2017, likely with some additional changes to the rules of the QE program to avoid hitting any self-imposed purchase limits.5 This could help keep spreads anchored near current levels, all else equal. Of course, all else is never equal, and the liquidity story can be trumped by expensive valuations, as we currently see in U.S. junk bonds. Using the same metrics for U.S. IG and HY credit spreads that we presented earlier shows that both the breakeven spread for Euro Area IG, and the default-adjusted spread for Euro Area HY, are below the long-run mean (Chart 13). Euro Area junk valuations are not as stretched as U.S. junk valuations on this basis, but they are hardly cheap. A similar story exists when looking at Euro Area IG corporates grouped by credit rating, with spread curves looking as flat as the U.S. curves shown earlier (Chart 14). Our Euro Area IG sector relative value model (Table 1 on Page 11) is also showing a handful of sectors with comparatively cheap spreads, ranging from commodity-focused industries (Energy, Metals & Mining) to financial groups (Insurers, Banks). However, the "cheapness" in the latter likely represents some degree of risk premium on Euro Area banks, whose poor profitability and capital adequacy issues are now well known to investors. Euro Area bank spreads may stay cheaper for longer until those problems begin to be addressed. Chart 14Euro Area Credit Spread Curves Are Flat Table 1Euro Area Investment Grade Corporate Sector Spread Valuations One final note on the relative value between Euro Area and U.S. corporates: the bottom-up Corporate Health Monitors for both regions that we introduced earlier this year continue to show gaps favoring Euro Area IG over U.S. equivalents (Chart 15), and U.S. HY over Euro Area equivalents (Chart 16). The relative balance sheet trends are showing up in the relative investment performance across the Atlantic, with Euro Area IG starting to outperform U.S. IG, and Euro Area HY lagging the returns in U.S. HY. We continue to recommend allocations based on these relative valuation trends, keeping the lightest weighting on Euro Area junk bonds that score poorly on all relative balance sheet metrics. Chart 15Favor Euro Area IG Over U.S. IG Chart 16Euro Area Junk Is Unattractive Vs. The U.S. Bottom Line: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay up in quality in Euro Area corporates, favoring Investment Grade over High-Yield. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "A Note On The Long-Term Outlook For Global Bonds", dated July 27, 2016, available at gfis.bcaresearch.com and usbs.bcaresearch.com 2 A neutral reading of the MCI is the zero line is consistent with a U.S. economy without any output gap, growing at its potential rate, and with unemployment at full employment levels. 3 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated Nov 1, 2016, available at usbs.bcaresearch.com 4 Source: Thomson Reuters I/B/E/S 5 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated Oct 25, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Beyond early last century's military rearmament, the idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis. If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global (but especially U.S.) defense stocks as a structural play will pay handsome dividends. The early-1960s experience in U.S. aerospace & defense (A&D) stocks is the closest stock market parallel we found in our analysis (given data constraints). Then, relative performance was up over 100% in a span of four years, as U.S. A&D industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95%. A&D factories were humming, racing to fulfill orders as U.S. military expenditures boomed. That demand surge translated into a jump in sector sales and given the industry's high operating leverage, earnings and book values soared. The chart shows that from trough to peak, sector EPS rose by more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled. That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the BCA U.S. defense index (that is a pure play on global defense spending). Bottom Line: Stay overweight the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL), and please see yesterday's Special Report for additional details.