経済成長
BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall Chart I-12China Is The Giant In The Room The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals Chart I-14Better Supply/Demand Backdrop For Oil We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump Chart I-16European Labor Market##br## Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (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: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 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: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 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: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 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: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 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
Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... Chart 2... Due To Rising Sales And Improving Margin Chart 3Developers' Improving Cash Flow And Balance Sheet In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve Chart 5Keqiang Index Versus GDP Growth Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted Chart 7Profit Recovery Helps Capex On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation Chart 9Housing: Another Major Downturn Is Unlikely Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility Chart 11Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The Fed's efforts to run a "high pressure" economy will create a self-reinforcing cycle where accelerating wage growth boosts household spending, leading to faster wage growth and even more spending. Stronger growth will prompt the market to price in more rate hikes over the coming years, propelling the dollar higher. A rising dollar will boost activity in the euro area and Japan. An improved economic outlook will push up inflation expectations in these economies, causing real rates to fall. This, in turn, will usher in a second virtuous circle in which lower real rates put further downward pressure on the euro and the yen, leading to even faster growth. Global equities are likely to struggle in the near term, as investors discount a more aggressive path for Fed tightening. Once the dust has settled, however, higher beta markets such as Europe and Japan should outperform in local-currency terms. We are closing our long Treasurys/short German bunds trade for a gain of 18%. Feature The Dollar Is Heading Higher Chart 1Most Forecasters Expect Household ##br## Spending Growth To Slow The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The first virtuous circle will push up real yields in the U.S., while the second will push down real yields in key economies such as Europe and Japan. Taken together, this will cause real yield differentials to widen sharply in favor of the U.S., sending the greenback higher. Virtuous Circle #1: Accelerating wage growth boosts U.S. consumption, leading to even faster wage growth and more spending. This forces the Fed to hike rates more than what the market is currently discounting. Real personal consumption has grown by 3% since mid-2013, even as the rest of the economy has expanded by a middling 0.7%. Most analysts expect consumption growth to decelerate next year to around 2.4%, based on Bloomberg estimates (Chart 1). There is no shortage of reasons for why consumer spending may slow. The drop in energy prices since mid-2014 has saved households an annualized $120 billion at the pump, and an additional $30 billion in the form of lower utility bills - equivalent to around 1% of disposable income. This has given households scope to increase spending on other items. Now that oil prices appear to have bottomed, this windfall will cease to grow. Rising asset prices have also stoked consumption. The S&P/Case-Shiller 20-City home price index has risen by 37% since early 2012, while the Wilshire 5000 index has gained 54% (Chart 2). Largely due to these developments, household net worth has increased from 538% of disposable income to 637% over this period, according to the Fed's Flow of Funds accounts. Looking out, we expect U.S. equities to deliver only 2%-to-3% real total returns over the coming decade. Home price appreciation should also flatten out, now that real home prices have moved back above their pre-bubble levels (Chart 3). Chart 2Rising Asset Prices Have Inflated Household Net Worth Chart 3U.S. House Prices Are Not Cheap Anymore Meanwhile, banks are starting to tighten lending standards in some consumer credit categories (Chart 4). Most notably, auto loan standards have tightened markedly, following a number of years of sharp easing. This could pose a headwind to vehicle sales in the coming year. Growth in aggregate hours worked has also decelerated over the past five quarters (Chart 5), a trend that should persist. We expect payroll growth to slow to around 100,000 a month in the next few years, as remaining labor market slack is absorbed. However, therein lies the upside for consumer spending. As the labor market begins to overheat, wage growth is likely to accelerate further (Chart 6). A one percent increase in wage growth boosts aggregate household income by as much as 120,000 additional jobs per month. Chart 4Consumer Lending ##br##Standards Are Starting To Tighten Chart 5Deceleration In ##br##Aggregate Hours Worked Chart 6Diminished Labor Market Slack ##br##Should Boost Wages Our sense is that the U.S. labor market is now approaching full employment. Granted, the employment-to-population ratio for prime-aged workers is still 2.3% below its pre-recession levels. However, as Chart 7 illustrates, this particular metric was trending lower even before the Great Recession began, suggesting that much of its decline is structural in nature. The data seems to bear this is out. Among the 23 million Americans between the ages of 25-to-54 who are currently out of the labor force, only 10.6% report wanting a job. This number is not much higher than before the crisis (Chart 8). The vast majority of nonparticipants are either homemakers, taking care of dependents, in school, claim they are ill or disabled, or have taken early retirement (Chart 9). Chart 7A Structural Downtrend In Labor ##br##Market Engagement Chart 8Not Many Potential ##br##Workers On The Sidelines Chart 9Most Who Do Not Work ##br##Choose Not To Work If the late 1990s is any guide, an overheated labor market is likely to push up labor's share of national income, allowing household earnings to grow more quickly than GDP. Back then, growth in aggregate wages and salaries among private-sector workers reached nearly 10% (Chart 10). Such blockbuster gains are improbable this time around owing to both lower structural productivity and slower labor force growth. Nevertheless, nominal wage growth could still rise to 5%-6% from the current lackluster pace of 3.7%, helping to bolster consumer spending. In addition, the experience of the 1990s suggests that a tight labor market will particularly benefit less-skilled workers (Chart 11).1 This is simply because less-educated workers are typically the first to be fired, and the last to be hired. Since poorer households tend to spend a larger share of their incomes, this will have a disproportionately large impact on consumption. Chart 10Lesson From The 1990s Chart 11The Real Beneficiaries Of A Tight Labor Market Would higher wage growth cause firms to reduce investment spending? The evidence says otherwise. Business investment has grown sluggishly in this economic recovery, even though profit margins have risen sharply. Thus, high corporate profitability is not a precondition for greater investment spending. If anything, business capex tends to increase during periods when the labor share of income is rising (Chart 12). This reflects the fact that business investment represents what economists call "derived demand." Firms typically expand capacity only when they feel that final demand for their goods or services will increase. Put differently, if consumers spend more, firms will invest more. Chart 12Firms Invest More When Workers Earn More The end result could be the emergence of a virtuous circle in which rising wages push up consumer spending, causing firms to hire more workers and invest in new capacity leading, in turn, to even faster wage growth. In fact, it is possible that the Fed's decision to let the economy run hot for a while pushes it towards an equilibrium where both aggregate demand and the neutral rate of interest - r* - are permanently higher. Chart 13 shows how such multiple equilibria can arise. Chart 13Double-Crossed: Multiple Equilibria In A Keynesian Demand Model Of course, at some point, the Fed would need to step in to cool things down by hiking rates more quickly than inflation is rising. This would translate into an increase in real interest rates, the consequence of which would be a stronger dollar. This is not just a theoretical possibility: The dollar has, in fact, tended to strengthen meaningfully whenever the labor share of income is rising and the jobless rate has fallen below its full employment level (Chart 14). Virtuous Circle #2: A stronger dollar boosts activity in the euro area and Japan. This pushes up inflation expectations in those economies, causing real rates to fall. Lower real rates put downward pressure on the euro and the yen, leading to even faster growth. How can stronger growth lead to higher real rates in the U.S. but lower real rates in Europe? The answer stems from the economics of liquidity traps. As discussed above, the U.S. economy is nearing full employment. As such, the Fed is no longer constrained by the zero lower bound on nominal interest rates. In contrast, inflation is well below target in both the euro area and Japan (Chart 15). This means that neither the ECB nor the BoJ will raise rates, even if growth picks up. What stronger growth will do in both economies is eat away at deflationary pressures. The upshot will be higher inflation expectations, lower real rates, and a weaker euro and yen. Chart 14Virtuous Dollar Circle #1 In Action Chart 15ECB And BoJ: In No Position To Tighten Admittedly, high levels of unemployment in Southern Europe will limit the extent to which stronger demand in those economies translates into higher inflation. Nevertheless, the region will still benefit from a weaker euro - and the boost to external competitiveness that this brings. Moreover, with the German unemployment rate at a 25-year low, a cheaper currency will generate more meaningful inflation in Europe's largest economy. This would help erode Germany's gigantic 8% of GDP current account surplus, which has been a key force in propping up the euro. It would also facilitate the "internal devaluation" that Southern Europe has to undertake without the need for grinding deflation in that region. We doubt that either the BoJ or the ECB would do anything to abort this virtuous circle. For his part, Governor Kuroda has stated that he wants inflation to rise above 2% in order to make up for the fact that inflation has consistently run short of the BoJ's target. To back up this pledge, the BoJ is giving the Ministry of Finance a blank check by promising to undertake unlimited bond purchases while keeping the 10-year yield pegged at zero. Thus, not only does the Japanese government need not worry about paying any interest on its debt, it also does not have to worry about repaying the principal, since the BoJ is buying more bonds than the government is issuing. Mario Draghi is also likely to lean into any inflationary tailwind. We expect the ECB to extend its asset purchase program at its December meeting for another six months, which is currently set to end in March 2017. The Governing Council may also signal that it will consider expanding the eligibility rules for bond purchases and modifying the existing capital key allocation. Investment Conclusions Two weeks ago, we argued that in the absence of Fed tightening, U.S. growth could reach 2.8% next year on the back of a turn in the inventory cycle, a pickup in business investment, and increased fiscal spending at the federal, state, and local levels.2 Consistent with Chair Yellen's desire to run a "high pressure" economy, the Fed would welcome faster growth, even if this pushes core inflation temporarily above 2%. However, memories of the 1970s have not fully gone away. Many of Yellen's FOMC colleagues, including former doves such as John Williams and Eric Rosengren, are already clamoring for higher rates. This means that if growth does pick up, the Fed will continue emptying the punch bowl. We expect the FOMC to raise rates twice next year, in addition to the 25 basis-point hike we are penciling in for December. This pales in comparison to the mere 54 basis points in hikes the market is pricing in through to end-2018 (Chart 16). Chart 16Market Rate Expectations Further Out Remain Muted Chart 17 shows that rate differentials between the U.S. and its trading partners have widened over the past four months, even as the dollar has traded sideways. Thus, even if rate differentials remain broadly constant, a case can be made for a stronger dollar over the coming months. The analysis above, however, suggests that rate differentials are likely to widen further. This should turbocharge any dollar rally. A 10% appreciation in the real broad trade-weighted dollar index may sound like a lot, but keep in mind that the dollar has weakened by 2% since January. Thus, we are only talking about a rise of 8% from where it was earlier this year. As Chart 18 shows, this would still leave the greenback 3% and 15% below its 2002 and 1985 peaks, respectively. Chart 17U.S. Rate Hikes Will Push Up The Dollar Chart 18Still Far From Past Peaks Chart 19Japanese And European Stocks Tend To Outperform In A Rising Yield Environment The current high sensitivity of the dollar to changes in interest rate differentials means that most of the tightening in financial conditions that the Fed will need to achieve over the next few years is likely to come through a stronger currency rather than higher bond yields. Nevertheless, yields are likely to drift higher. Consistent with the views of our Global Fixed Income Strategy service,3 at this point, we see more upside for Treasury yields than for yields in most other developed markets. With that in mind, we are closing our long Treasurys/short German bunds trade for a gain of 18%. Turning to equities, the need for the market to price in a more aggressive path for Fed tightening poses near-term downside risks to global stocks. We remain tactically cautious. Once the dust has settled, however, higher beta equity markets are likely to outperform. As my colleague Anastasios Avgeriou has highlighted, European and Japanese stocks generally do well in a rising yield environment (Chart 19). Moreover, as Chart 20 illustrates, such an environment could benefit global banks shares, which remain among the most despised sectors of the market.4 Chart 20AHigher Yields Would Benefit Banks... Chart 20B... As Would Steeper Yield Curves Our bullishness does not fully extend to emerging markets. An appreciating dollar could hurt EMs in three ways. First, a stronger dollar could weigh on commodity prices. Second, it could punish EM borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits. Some emerging markets rank higher on this list of vulnerabilities than others. China, for instance, ranks relatively low, given its current account surplus, moderate levels of external debt, and its status as a net commodity importer. As such, while we expect the RMB to weaken against the dollar, it is likely to strengthen on a trade-weighted basis. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 For example, see Harry J. Holzer, Steven Raphael, and Michael A. Stoll, "Employers In The Boom: How Did The Hiring Of Less-Skilled Workers Change During The 1990s?," The Review of Economics and Statistics, Vol. 88:2 (2006), pp. 283-299. 2 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 3 Please see Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes," dated October 18, 2016, available at gfis.bcaresearch.com. 4 Please see Global Alpha Sector Strategy , "The Great (Debt) Wall Of China," dated May 27, 2016, available at gss.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades
Highlights We expect the U.S. House of Representatives to remain in GOP hands, but the Democrats could take razor-thin control of the Senate if Clinton wins the Presidency. The current, market-bullish status quo of divided government will continue. The chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. We would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support in the U.S. for removing the sequester, opening the door to some fiscal stimulus. A shift in focus from monetary to fiscal policy will be quite bullish for the dollar, which could rise by 10% in trade-weighted terms. The Japanese government appears to be preparing another shot of fiscal stimulus, which would be quite bearish for the yen and bullish for Japanese stocks when combined with the Bank of Japan's new yield curve policy. A number of headwinds that have held back U.S. growth this year will give way, generating 2½-3% real GDP growth in 2017. Positive growth surprises will encourage the FOMC to tighten in December and another five times over 2017/18. However, the speed of rate hikes will depend on how quickly the dollar appreciates. Dollar appreciation will undermine U.S. EPS growth next year. We view this as a headwind for stocks, but not something that will prevent modest gains in the S&P 500 next year. A key risk is that a surging dollar and a more hawkish FOMC sparks a correction in EM assets in the near term, spilling over into developed market bourses. Given elevated valuations, the risk/reward balance still favors a defensive strategy, with no more than a benchmark allocation to stocks. Several trends support our recommendation to maintain slightly below-benchmark duration within fixed- income portfolios. Among them, the annual growth rate in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over. Continue to overweight indexed bonds versus conventional issues. Oil prices should be able to hold up in the face of dollar strength given that we expect the tightening oil market will dominate. However, base metals will struggle. Feature As we go to press, Hillary Clinton is poised to win the Presidency of the United States following a tumultuous and divisive campaign. The key question now is the Senate race, where less controversial Republicans are contesting close elections. The GOP is at high risk of losing four Senate seats, with another three in play. Democrats need only four seats to take the Senate because, assuming that Clinton wins the presidency, Vice-President Tim Kaine would then cast the tie-breaking vote in that body. We expect the GOP to hold onto the House. This means that the current, market-bullish status quo of a divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate, the Clinton White House would be constrained on some of its most left-leaning policies. Unlike Obama, Clinton's victory will not be a popular sweep. She will likely receive less than 50% of the popular vote and will be the first candidate ever elected that has more voters saying they dislike her than like her (Chart I-1). Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting mandate as Obama did in 2008. Chart I-1Clinton And Trump: The Least Charismatic Candidates Ever Nonetheless, BCA's Geopolitical Strategy service believes that the chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. On corporate tax reform, it is difficult to see a reduction in effective tax rates, but a deal could be struck to broaden the tax base by closing various loopholes. This would be negative for some S&P 500 multinational corporations, but would benefit America's small and medium-sized enterprises. Paul Ryan and moderate Republicans understand that there has been a paradigm shift in America and that the median voter has moved to the left. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support for removing the sequester. Even a modest infrastructure plan could make a substantive difference for the economy given the high fiscal multipliers of government spending in an economy with low interest rates. The political shift to the left means that a Clinton-Ryan coalition will care less about the concerns of America's large corporations than previous governments, leading to policies that will result in higher effective tax rates on major corporations, a dollar bull market (in conjunction with tighter Fed policy, see below), and rising wages over the next four years. The election outcome will also be positive for bombed-out U.S. health care stocks. Even if the Democrats take the Senate, a Republican-held House will make it difficult for Clinton to push through legislation that does serious damage to the sector's pricing power. Health care stocks are oversold and cheap, at a time when consumer demand is solid and our pricing power proxy is rising much more quickly than overall corporate sector pricing. In terms of the macro implications, a shift in focus from monetary to fiscal stimulus will be quite bullish for the dollar. Below we discuss the important changes coming in the global investment landscape stemming from a renewed dollar bull phase. U.S. Growth: Expect Upside Surprises Any boost to U.S. infrastructure spending is unlikely to show up in GDP until the second half of next year. Nonetheless, there are other reasons to be more upbeat than the consensus on growth prospects for the first half as well. It is important to note that U.S. real final sales to private domestic purchasers, a good measure of underlying demand growth, has grown at almost 2½% over the past year, and was up 3.2% in the second quarter sequentially. A number of headwinds conspired to hold back the headline GDP growth figures, but these headwinds should moderate next year (Chart I-2): The five-quarter inventory correction is almost unprecedented in its length, but there are some high-frequency indicators (i.e. durable goods inventories and the inventory component of the ISM manufacturing index) that suggest that the correction is coming to an end (Chart I-3). Inventory destocking only needs to stabilize to boost GDP growth, since it is the change of the change in inventories that affects GDP growth. Chart I-2U.S. 2016 Growth Headwinds To Fade Chart I-3Inventory Rebuilding Has Commenced Some of this year's slowdown reflects a pullback in the contribution of federal and state & local government spending. Nonetheless, this will not last long because state and local government revenues are trending higher and this sector spends all it takes in. As noted above, we also expect a boost from infrastructure spending at the federal level. Housing starts and residential investment hit a soft patch this year. The second quarter dip was mainly due to a warm winter, which pulled forward home-improvement spending. The NAHB homebuilders index heralds a rebound in housing activity in the coming months, in line with the improvement in household formation. Indeed, housing starts are still 20-25% below estimates of the amount of construction necessary to keep up with population growth. We also expect a little more capital spending once the election is out of the way, profits begin to expand again and industrial production growth improves early in the New Year. Moreover, the oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. Overall corporate capital spending intentions have perked up (Chart I-4). The trade sector will be a drag on growth, especially if the dollar appreciates as we expect. Nonetheless, we believe that the unwinding of the other headwinds that have dogged the economy this year could provide real GDP growth of 2½-3% in 2017. Stronger-than-expected growth will have a positive impact on America's trading partners via import demand, but it is the response of the dollar that could really shake up global financial assets. The reasoning behind our strong dollar view is straightforward: interest rates differentials are the strongest predictor of currency trends on a 12-18 month horizon. Relative economic performance between the U.S. and the rest of the world suggests that interest rate differentials will move even further in favor the U.S. dollar. Chart I-5 highlights that the dollar tends to appreciate when U.S. interest rates are in the upper half of the interest rate distribution of the G10. With few central banks outside of the U.S. in a position to be able to lift interest rates, gently rising U.S. rates will keep the U.S. among the global developed market (DM) high-yielders for many years. Chart I-4Capex Plans Have Improved Chart I-5U.S. Sitting Atop The Global Interest Rate Distribution Buoys The Dollar Real interest rate differentials may shift even more than nominal rates in favor the dollar. Inflation expectations should rise in Europe and Japan to the extent that their respective currencies weaken and their economies receive a boost from improved U.S. import demand. But since neither central bank will allow much of an increase in local bond yields, rising inflation expectations will translate into lower real yields in the Eurozone and Japan. This will reinforce the dollar's bias to appreciate. The ECB could upset this forecast by announcing that it will taper the asset purchase program beginning in March of next year, but we believe it is more likely the central bank will extend the QE program for another six months. In Japan's case, the nominal yield curve is now fixed by the Bank of Japan out to 10-years. How Much Will The Dollar Appreciate? This is a difficult question. 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. Our sense is that over the next couple of years the fed funds rate will need to rise to 2% in nominal terms (0% in real terms) and the dollar will appreciate by 10% in trade-weighted terms, to avoid an economic overheating and an overshoot of the inflation target. We expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. But, of course, an outsized dollar response to the initial rate hikes would temper the speed of Fed tightening. A 10% rise seems aggressive, but it would still leave the broad trade-weighted dollar index well below previous peaks. Wouldn't Such A Dollar Surge Kill Any Hopes Of A Recovery In U.S. Profits? Undoubtedly, dollar strength presents a direct and non-trivial risk to the earnings outlook. Our U.S. EPS model foresees a return to positive earnings growth early next year, and a full-year expansion of 5-6% (Chart I-6). This is based on three important assumptions: (1) industrial production returns to modest but positive growth next year; (2) oil prices are roughly unchanged from current levels, allowing profits in the energy patch to recover with a lag; and (3) nominal GDP growth accelerates modestly relative to labor compensation. Chart I-6The U.S. Profit Outlook However, we assumed in the base case scenario presented in May that the dollar is unchanged. Re-running the model with a 10% dollar appreciation over the next year would shave about 2-3 percentage points off of EPS growth next year (Chart I-6). In other words, EPS would rise next year, but only modestly. Can The S&P 500 Rally In The Context Of Dollar Strength? Chart I-7Stocks Can Appreciate With The Dollar An appreciating dollar is clearly a headwind, but it is the case that the S&P 500 rallied along with the dollar in the last three major dollar bull markets: 1978-1985, 1994-2002, and 2011 to today (Chart I-7). One could point to special factors in each episode. Nonetheless, our point is that if the dollar is appreciating because growth outside the U.S. is deteriorating, then the backdrop is negative for U.S. equities. But if the dollar is appreciating because the U.S. economic growth backdrop has brightened (with no deterioration elsewhere), then U.S. stocks can rally despite the negative impact of the dollar on profits. Indeed, the direction of causation reverses at times: it is the rally in U.S. risk assets (along with higher rates) that attracts foreign capital and pushes the dollar higher. A tax holiday on foreign retained earnings would also be positive for the dollar and risk assets. That said, the currency shifts we expect over the next year will favor Eurozone and Japanese stocks to the U.S. market in local currency terms. This is particularly so for Japan if more aggressive monetary and fiscal policies manage to sharply devalue the yen (see below). According to our models, a 5% depreciation of the euro and a 10% drop in the yen in trade-weighted terms would boost EPS growth next year by 3 and 5 percentage points, respectively, in the Eurozone and Japan (Chart I-8). Monetary policy divergence and relative valuation also support our recommendation to favor Japanese and Eurozone stocks versus the U.S. Chart I-8The Eurozone Profit Outlook What Does Our Dollar Outlook Mean For EM Assets? Continuing liquidity injections from the ECB and BoJ are positive for emerging market (EM) assets. Unfortunately, this will not shield emerging markets from a 10% dollar rise, especially if it is accompanied by another downleg in commodity prices (Chart I-9). A stronger greenback is likely to cause distress among over-leveraged EM borrowers given that 80% of EM foreign-currency debt is denominated in dollars. Chart I-10 illustrates that there have been no periods when EM share prices rallied amid strength in the trade-weighted U.S. dollar since the early 1980s. Meanwhile, the gap between EM and U.S. nonfinancials' return on equity (RoE) remains deeply negative, which historically has been associated with EM currency depreciation. Chart I-9Dollar Strength Is Negative For Commodities... Chart I-10...And Emerging Markets The implication is that the recent rally in EM risk assets and currencies will not last. Investors should avoid this space. A dollar rally would also be a headache for the People's Bank of China (PBoC). Allowing the RMB to depreciate aggressively versus the dollar to avoid an appreciation in trade-weighted terms could ruffle political feathers in the U.S. and spark capital flight. The PBoC will likely manage the RMB's decline versus the dollar and allow it to appreciate in trade-weighted terms, while tightening capital account controls to prevent capital from fleeing the country. This outcome is slightly negative for the economy and could generate some financial market volatility as the process unfolds. We believe that China will be able to maintain GDP growth of around 6½% next year and that there will be no financial crisis related to China's high debt levels. Nonetheless, China's transition away from an investment-led to a consumer-led expansion means that the tailwind for commodity demand and EM exports will not return. FOMC: Some Like It Hot The probability of a Fed rate hike in December eased a little in recent days due to some disappointing economic data, such as the September readings on retail sales and the CPI, along with comments from Fed Chair Yellen on the benefits of allowing the economy to "run hot". Some others on the FOMC share her views, but many do not. As we highlighted in last month's Special Report,1 Yellen will not overrule the consensus on the FOMC. The appetite to test the limits of the supply side of the economy is simply not broad enough, as visions of the inflationary 1970s still loom large in some policymakers' minds. The Fed may end up being too slow in tightening policy and generate an overheated economy by accident, but the idea of purposefully engineering a temporary inflation overshoot is off the table. The hawkish shift in the consensus can be observed in the latest FOMC minutes. Not only did three members vote for a rate hike in September, but "several" members felt that a rate hike was a "close call". The remaining doves often point out that the Fed's preferred measure of inflation, core PCE, is still below the 2% target. However, this measure is an outlier; all other popular measures of underlying inflation are near or above 2% and are in a clear uptrend. Wage growth, although somewhat mixed across the various measures, is also trending up (Chart I-11). The doves already lost two members this year (Williams and Rosengren). More will jump ship if core PCE moves up in the coming months as we expect, although a 10% dollar appreciation by itself could shave almost a half point off of inflation next year (Chart I-12). Chart I-11U.S. Wage Pressure Is Growing Chart I-12The Inflation Impact Of Dollar Strength Recent data disappointments are a concern, but the bounce in both the ISM manufacturing and nonmanufacturing surveys in September, especially in the new orders components, is a sign that the soft patch will not endure. It would require a significant disappointment in the October and November payroll reports for the FOMC to stand pat at the December meeting. Beyond this year, our base-case outlook calls for five quarter-point rate hikes over 2017 and 2018, compared to only two rate hikes currently discounted in money markets. This forecast is uncertain because an even larger portion of the overall tightening in monetary conditions than we expect could come via the dollar. Indeed, there is a significant risk that dollar strength and Fed tightening sparks a correction in risk assets. The TINA phenomenon (There Is No Alternative) has forced many investors to take more risk they are comfortable holding. Valuations are also rich. This is the main reason why our investment recommendation is cautious, including only a benchmark allocation to equities in a balanced portfolio. We maintain that stocks will outperform bonds and cash on a 1-2 year horizon, although total returns will be depressed by historical standards. Moreover, we would not be surprised to see a 10% correction in the major equity bourses in the coming months. Investors with a short-term horizon should consider buying some insurance against this risk. What would it take for us to upgrade stocks to overweight? We would like to see significant fiscal stimulus in some combination of the U.S., Eurozone and Japan. It would be particularly bullish if the stimulus occurs outside the U.S., because a pickup in global growth would allow the Fed to tighten without driving the dollar significantly higher. This scenario would improve the outlook for equities inside and outside of the U.S. Finally, a 10% equity correction would create enough value that we would be quite tempted to upgrade the sector. Japan Prepares For The Next Step The dollar's ascent will be particularly acute versus the yen if we are right that more aggressive policy action looms in Japan. We argued in last month's Overview that fiscal stimulus will be particularly powerful in the context of the Bank of Japan's (BoJ) new policy framework. Instead of targeting a pace of asset purchases, the central bank is effectively fixing the yield curve by promising to hold the 10-year yield near to zero. By fixing the yield curve and by committing to maintain this policy until Japanese inflation moves above the 2% target, the BoJ is hoping to raise inflation expectations and drive down real bond yields. Fiscal stimulus in this environment would be quite effective because nominal yields would not be allowed to rise in response. Any increase in inflation expectations would flow directly into lower real yields and weaken the yen, thus reinforcing the initial thrust of fiscal policy. The timing and amount of additional fiscal spending is not clear, but the Japanese Diet is currently deliberating the third revision to the second supplementary budget. Government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. Any efforts to boost income will add to upward pressure on actual inflation and inflation expectations. Given that the market is discounting inflation of only 0.26% per year on average over the next 20 years, the balance of risks favors an inflation rate that surprises to the upside. The resulting downward pressure on real interest rates, at a time when U.S. real rates will be rising, will depress the yen. Our currency experts expect the yen to weaken to 125 versus the dollar, representing a decline of roughly 10% in trade-weighted terms. We estimate that this would add about a half point to Japanese headline consumer price inflation next year (Chart I-12). A successful policy push would ultimately be quite bearish for JGBs. However, a critical element in the plan is that the BoJ prevents a premature rise in nominal yields. We do not expect any JGB selloff for at least a year. This means that, while total returns for JGBs will be poor (or negative for some maturities), the market will outperform the other major government bond markets in currency hedged terms if global yields rise in the coming months as we expect. The implication is that investors should favor JGBs over Bunds and, especially, Treasuries within global hedged bond portfolios. Also, stay long inflation protection in Japan, overweight the Nikkei and underweight the yen. Reason To Be Bond Bearish Chart I-13Reasons To Keep Duration Short Our fairly hawkish view on the Fed is a key factor behind our recommendation to keep duration slightly short of benchmark within bond portfolios. More broadly, the global deflation beast is far from tamed, but the firming in selected commodity prices is reducing some of the downward pressure on inflation in the advanced economies. Oil prices have breached $50/bbl on hopes that OPEC-Russia talks will result in production cuts. Our commodity strategists do not expect any agreement to have much of a lasting impact on oil prices. Indeed, there is a risk that oil prices correct if the talks ultimately fail. However, we still expect WTI to trade between $40 and $65/bbl until 2020. The annual growth rate for the continuous commodity index has reached positive territory for the first time since 2014, which is translating into a more positive pricing environment for manufactured goods and overall headline inflation rates for both developed and emerging economies (Chart I-13, bottom panel). This has given inflation expectations a boost in the major markets, at a time when output gaps in developed countries are narrowing (the gap is near to being fully closed in the U.S.). Several other factors favor a below-benchmark duration stance at least for the near term (Chart I-13): Global growth is improving slowly. The global leading economic indicator (LEI) is rising and our diffusion index shows that 10 of 15 countries have rising LEIs. We expect the U.S. economy, in particular, to surprise to the upside. The prospect of even a little fiscal stimulus is bond bearish, following years of austerity in the major developed countries. The downward pressure on global term premia is dissipating as the BoJ has switched away from quantitative targets for asset purchases to fixing the yield curve. The ECB is likely to extend the QE program by another six months, but the central bank is unlikely to lift the pace of purchases from the current level. The annual percent change in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over (Chart I-14). Chart I-14Liquidity Growth Peaking Out The market expects that real short-term interest rates will stay in negative territory until at least the middle of the next decade, even in the U.S. There is plenty of room for the forward yield curve to reprice higher if growth turns out to be better than expected. This is particularly the case in the U.K., where fears of a post-Brexit economic bust and a fresh shot of stimulus from Bank of England sent the pound and gilt yields to extremely low levels. Our global bond and currency services recommend taking profits on overweight gilt/underweight sterling positions, and shifting in the opposite direction. Finally, bond sentiment indicators are still bullish, particularly in the U.S. Treasury market. Nonetheless, we are far from frothing bond bears. We do not believe that the fixed income market has moved into a secular bear phase, and would likely shift to benchmark or even above-benchmark duration if the 10-year Treasury yield reached 2%. Yields could eventually re-test the year's lows if there is a sharp equity correction. This is a market to be traded for now. Conclusions A more upbeat view on global and, especially, U.S. growth prospects is positive for risk assets, but the adjustment process could be painful as investors come to grips with what this means for the Fed. Extremely low Treasury yields imply that the consensus has "bought into" the Secular Stagnation thesis for the U.S., or at least to the view that America will never again be able to grow above 2%. The pickup in growth we expect will arrive at a time when there is accumulating evidence of an acceleration in wages, signaling that the labor market has reached full employment. A shift in focus away from monetary and toward fiscal stimulus, both inside and outside the U.S., is also bond-bearish. The bond market appears to be ignoring these trends so far, although rising inflation expectations suggest that we may be at the edge of a change in market expectations for growth, inflation and the Fed outlook. A significant shift up in the dollar would limit the bond market selloff, and it would be positive for the major economies outside of the U.S. Nonetheless, a 10% dollar appreciation would carry its own risks, including a hit to the U.S. profit outlook. On its own, dollar strength would not prevent the S&P 500 from rising, but there is a non-trivial risk that it wreaks havoc in the EM and commodity space for a time, reverberating back into developed markets. The bottom line is that investors should remain focused on capital preservation, with no more than an overall benchmark weighting in equities with a bias toward defensive sectors. Within bond portfolios, keep duration on the short side and favor high-quality spread product to government bonds in the major countries. High-yield bonds would benefit from stronger-than-expected economic growth in the U.S., but value is poor and balance sheets are deteriorating; the risk/reward balance is unattractive. European investment-grade bonds issued by domestic issuers are more attractive than the U.S. market because of improving balance sheet health. Favor real-return bonds to conventional issues in the major countries and add exposure to floating-rate notes. Our dollar view means that base metals should be avoided, despite the fact that we expect that China will be able to stabilize growth at around 6-7%. Oil should be able to hold up in the face of dollar strength given that we expect a tightening oil supply/demand backdrop. Both gold and silver would weaken if the dollar continues to appreciate and real bond yields rise in the near term. Nonetheless, rising inflation should overwhelm these negatives in the medium term. This implies that precious metals deserve a strategic place in investors' portfolios, although the near-term could be rough. Finally, we have received many questions on the risks posed by mushrooming U.S. student debt. This month's Special Report, beginning on page 19, takes an in-depth look. We conclude that student debt is a modest economic drag, but is not a source of risk to the government's finances and does not represent the next "subprime" crisis. Mark McClellan Senior Vice President The Bank Credit Analyst October 27, 2016 Next Report: November 24, 2016 1 Please see The Bank Credit Analyst, "Herding Cats at the Fed," October 2016, available at bca.bcaresearch.com II. Student Loan Blues: Can't Repay What I Borrowed Incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages. Some are comparing this trend to the housing subprime crisis, arguing that student debt is a major drag on growth at a minimum, and the source of another financial crisis at worst. Delinquency rates have surged and the 5-year cumulative default rate on student debt has reached almost 30%. Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%. Sticker prices at most institutions have mushroomed, although few students pay the full fare. Rising tuition fees only explain about half of the surge in student debt. Education still pays, although the benefits have waned versus the costs. Moreover, students with debt lag significantly those with no debt in terms of wealth accumulation and home ownership after graduation. The rise in default rates have been due to the influx of non-traditional student borrowers after 2007, who come from lower income families and have had poorer educational and employment outcomes. However, the wave of such borrowers has faded, which means that overall delinquency and default rates will decline in the coming years. Debt service payments, while onerous for many families, are not a major drag on overall real GDP growth. The increased propensity of 18-35 year-olds to live with their parents has trimmed annual real GDP growth by 0.14% per year since 2007, although student debt is only one of many underlying causes. The student loan program is at worst only a minor drain on the Federal government's coffer because of the high recovery rate. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Student debt is not the next subprime. "We are not doing these young people any favors by giving them loans that they cannot afford, that they cannot discharge in bankruptcy, and that could be a drag on their financial well-being even into retirement". - Sheila Bair, former FDIC chief, Bloomberg interview, September 26, 2016 Ms. Bair was one of the first to warn about the risks posed by the U.S. subprime MBS market, well before Lehman went bust. Few were listening then, but more are listening now as she sounds the alarm bell regarding student loans. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages (Chart II-1). Ms. Bair notes that, like the MBS market before 2007, cheap and freely available credit is fueling prices (tuition in this case). Banks handed out mortgage loans to many who could not afford them in the 2000s, just as the Department of Education (DoE) is doing today with student loans. It is difficult to assess borrowers' ability to repay student loans. Some argue that the DoE is not even trying. The trajectory of student debt is indeed alarming (Chart II-2). In inflation-adjusted terms, the total value of loans outstanding has quadrupled since 2000, representing an annual average compound rate of 9.4%. The rise reflects both an increase in the number of borrowers and more borrowing per person. Average debt/person has jumped from $17,300 in 2007 to almost $28,000 in 2015 (amounts vary across data sources). Rising debt levels occurred across the family income distribution. Chart II-1Student Debt: The Next Subprime? Chart II-2Student Loan Statistics These figures understate the true debt levels because they include only loans that are made under the federal loan program, representing 81% of the total. The remainder are private loans, mostly originated by banks. Private loans do not enjoy the same borrower protection afforded to federal loans, and carry a significantly higher interest rate (average of almost 14% in 2016, compared to federal loan rates of 3.76%). The data on private loans are sparse due to limited reporting, but a study based on 2012 data showed that the average amount of debt for students with private loans was almost $40,000 at that time.1 Sticker Shock It is easy to blame rising tuition fees given soaring "sticker prices" at most institutions. The average posted fee for tuition and room & board has increased by 30% in inflation-adjusted terms since 2007 at public universities, and by 23% at private non-profit institutions (Charts II-3A & II-3B). However, due to grants, tuition discounts and tax credits for education, only a small fraction of students pay the posted rate. For the 2015/16 school year, the net price that the average student paid at a private non-profit institution was $26,400, far less than the almost $44,000 sticker price. Chart II-3ATuition & Fees: Public Institutions Chart II-3BTuition & Fees: Private Institutions Chart II-4The Distribution Of Student Debt The Brookings Institute estimates that only about 50% of the escalation in student debt in the past two decades can be explained by rising tuition costs.2 Another quarter reflects rising educational attainment; kids are staying in school longer to get a leg up in the highly competitive workplace. The remainder of the total rise in debt was left unexplained in the study. Other possible contributing factors include policy changes that expanded eligibility for federal loans programs, and the housing bust that made it more difficult for families to borrow against the value of their homes for education purposes. There was also a change in the background characteristics of borrowers after the Great Financial Crisis (see below). The share of students suffering with an extraordinary amount of debt is growing, although they still represent a small portion of the total for federal loans (Chart II-4). Five percent of student debtors owe more than $100,000 each, up from 2% in 2007. Another 10% hold between $50,000 and $100,000. About two-thirds of student borrowers owe less than $25,000. A Student Debt Crisis? Another Brookings paper provides estimates for the debt service burden associated with federal student loans. The burden is calculated as the median debt service payment divided by median earnings of employed borrowers for two years after entering the repayment period (Chart II-5).3 This ratio rose from about 4½% in 2004 to 7.1% in 2013. Unfortunately, more recent data are not available. The average interest rate on the outstanding loans has moderated since 2011, although not nearly as quickly as the drop in market interest rates.4 Nonetheless, the continued escalation in the stock of debt per person in recent years means that the debt service-to-income ratio has likely continued to escalate since 2013, despite the moderation in the average interest rate paid. The jump in student loan delinquencies has raised red flags regarding the number of borrowers in financial distress, feeding concerns that a student loan debt crisis is on the horizon. The 90-day delinquency rate for student loans has increased from about 7% in 2007 to 11% in 2012, where it has hovered ever since according to the Federal Reserve Bank of NY data (Chart II-1). However, since only about 55% of all loans are in the repayment period, the actual delinquency rate among those in repayment is almost double the official figures. Loans are considered to be in default when they are more than 270 days past due. Brookings estimates that the 5-year default rate for student loans entering the repayment period five years earlier reached 28% in 2014, up from 16% for the five-year period ending in 2007 (Chart II-6).5 Perhaps surprisingly, the default rate is still far below the peak rate of more than 40% in the late 1990s. Chart II-5Debt Service Burden Is Rising Chart II-6Defaults Are Rising Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%.6 This is because borrowers are not able to discharge federal student debts during bankruptcy. Congress has passed legislation making it very difficult for borrowers to avoid repaying. The DoE has the authority to use a number of extraordinary collection means. These include garnishing a portion of borrower's wages or seizing any payment a borrower may receive from the federal government. Education Still Pays, But Not For Everyone Chart II-7Debt And Wages For 20-40 Year Olds The good news is that education still pays for the average or median borrower. Chart II-7 shows that, while the average amount of student loans has escalated, it is still well below the average wage for those borrowers in the 20 to 40-year age group.7 The gap between wages and debt has narrowed over the past 15 years, but the increase in lifetime earnings potential still far exceeds the rise in accumulated debt for the average or median student. Of course, student loans have not paid off for everyone. News reports have highlighted plenty of examples of students that have graduated with crushing debt burdens and poor job prospects. Nonetheless, the Brookings study found that, for the vast majority, "the increase in borrowing would be made up for relatively early in the career of a worker with mean earnings".8 The Digest of Education Statistics show that, in 2013, the median annual earnings for full-time workers with a Bachelor's degree in the 25 to 34 age group was $48,530, compared with $30,000 for workers with just a high-school diploma. The bad news is that it is taking much longer to repay these debts. The mean term of repayment has increased from 7½% in 1992 to about 13½ years in 2010.9 Extended repayment and income-driven repayment plans can increase the loan term to 20, 25 or even 30 years. In some cases, borrowers will still be paying for their education when their children enter college!10 There is also evidence that the debt burden is causing some young adults to delay marriage and live with their parents for longer than they otherwise would. More Debt And Less Wealth Young student debtors also lag significantly relative to their peers in terms of wealth accumulation. A Pew Research Center study found that households headed by a young, college-educated adult without any student debt obligations have about seven times the typical net worth ($64,700) of households headed by a young, college-educated adult with student debt ($8,700; Chart II-8).11 Net worth is lower for those with student loans not just because their overall debt levels are higher; the value of their assets trailed as well. This gap is despite the fact that those households with a degree had almost double the annual income of those in the study that did not. Even comparing only households headed by young adults that did not attain a degree, accumulated wealth for those with student debt fell far short of those who avoided debt. One explanation is that money being absorbed by student debt repayment is unavailable to accumulate assets. A Federal Reserve Bank (FRB) of Boston study12 estimated that a 10% increase in student loan debt per household is associated with a 0.9% decline in the value of total wealth. Student loan burdens also mean that households end up relying more on other types of debt, such as auto loans and credit cards, according to the Pew study. Chart II-8Higher Debt, Lower Wealth... Table II-1...And Lower Homeownership Student debtors are also less likely to own a home after 2009 (Table II-1). Before 2009, the FRB of Boston study found that 30-year olds with a history of student loans had a higher homeownership rate than those without student debt. This makes sense because the boost to household income from obtaining more education should make it easier to quality for a mortgage. However, the relationship between student debt and homeownership switched after the Great Recession. The economy-wide homeownership rate has fallen sharply since home prices peaked in 2006, but the drop was more severe for those with student loans. This is probably due to the erosion in future income expectations following the recession for those with student debt, as well as more limited access to additional credit based on these individuals' existing debt loads (i.e. lower credit scores). Alternatively, student debtors may simply be reluctant to add to their overall leverage in light of the more uncertain economic outlook. A Fed study estimated that every 10% increase in student debt per person now results in a 1 percentage point drop in the homeownership rate for the first five years after graduation.13 Non-Traditional Borrowers Led The Surge In Delinquencies... While student debt burdens are unlikely to ameliorate anytime soon, the default rate should moderate in the coming years. Brookings (2015) conducted a detailed assessment of the characteristics of student loan borrowers and how they changed after 2007, by matching administrative data on federal student borrowers with earnings data from tax records. The study split the sample into "traditional" and "non-traditional" borrowers. Traditional borrowers are defined to be those attending 4-year public and private institutions because they tend to be typical in nature; they start college in their late teens, soon after completing high school, are dependent on their parents for aid purposes, pursue 4-year degrees and, frequently, head on to graduate study. This group historically represented the majority of federal borrowers and loan amounts. Non-traditional borrowers historically made up only a small portion of the total. These are defined to be those borrowing for 2-year programs (primarily community college) or to attend for-profit schools. The study found that non-traditional borrowers have largely come from lower-income families, tended to be older (i.e. not supported by parents), attended institutions with relatively low completion rates and faced poor labor market outcomes after leaving school (Chart II-9). Lower median wages and higher rates of unemployment meant that non-traditional borrowers tended to default on their student loans at a higher rate than traditional students. Student borrowing is counter cyclical; it tends to accelerate during recessions as unfavorable labor market conditions encourage people to return to school or to stay in school longer. The flow of new borrowers accelerated particularly sharply during the Great Recession, as intense pressure on State budgets led to cuts in scholarships by public institutions. Access to alternative credit markets was also curtailed during and after the Great Financial Crisis. Chart II-9Non-Traditional Students Had Poor Labor Market Experience Chart II-10Surge In Non-Traditional ##br##Borrowers After 2007 Student loan inflows (i.e. the number of new borrowers) and outflows (the number paying off loans) are shown in Chart II-10. Inflows trended higher from 2000 to 2007, while outflows were fairly flat, leading to an upward trend in the net inflows. Inflows subsequently surged during the recession, reaching a peak in 2010. The jump in new borrowers was concentrated among non-traditional students. The number of non-traditional borrowers grew to represent almost half of all new borrowers soon after the recession. The wave of students who had begun to borrow during the recession entered the repayment period in increasingly large numbers from 2011 to 2014. The early years of repayment are the most precarious because debtors are just starting their careers and their earnings are the most variable. The rise in the share of non-traditional borrowers largely explains the surge in the overall default rate since 2011. In contrast, the majority of traditional borrowers have experienced strong labor market outcomes and relatively low rates of default. Of all the students who left school, started to repay federal loans in 2011, and had fallen into default by 2013, about 70% were non-traditional borrowers. ...But The Worst Is Over The situation has since begun to reverse. Inflows and the net change in the number of borrowers has declined since 2012, particularly at 2-year and for-profit institutions. The moderation of the pace of inflows, the change in the composition of borrowers (less non-traditional), and efforts by the DoE to expand the use of income-based repayment programs will put downward pressure on delinquency and default rates in the coming years. Economic Impact Of Student Debt There are several channels through which rising student debt can affect overall economic growth. Spending by households with student debt will be curtailed both by the need to service the loans and by the fact that these households have lower levels of net worth. They are also less likely to own a home or form a small business. (1)Debt Service Burden And The Wealth Effect Table II-2 presents estimates of the value of aggregate debt service payments as a percent of GDP. This is based on the median debt service-to-earnings estimates from the Brookings Institute and median income for households where the head is less than 35 years of age in the Survey of Consumer Finances. If we assume that every dollar paid to service student loans is a dollar not spent on goods and services, then Table II-2 implies that the resulting drag on the level of real GDP has doubled from 0.17% of GDP in 2004 to 0.34% in 2013 (latest year available). However, it is the increase over time that matters for GDP growth, not the level. The rise of 0.17% was spread over nine years, suggesting that the drag on GDP growth was minimal. Moreover, this represents an overestimate of the actual drag, because households with student debt have leaned more heavily on other types of debt in an attempt to maintain their living standards. Table II-2The Debt Service Drag On GDP Lower levels of asset accumulation and net worth will also undermine consumer spending. However, we believe that accounting for both the "wealth effect" and the debt-service effect on GDP would be double counting. Chart II-11Spending On Education ##br##Not A Growth Driver Education spending also provides a possible offset to the negative impact of debt service on GDP growth. However, in terms of household spending on education, in inflation-adjusted terms there has been virtually no growth in consumer spending on higher education over the past 15 years despite all the extra spending in nominal dollars (Chart II-11). Data on government spending specifically on higher education is not available, but spending on all levels of education including primary and secondary schools has declined as a fraction of real GDP since the early 2000's. The implication is that total spending on higher education by households and governments has not provided any offset to the drag on GDP growth from student debt since 2007. (2)Housing Market Earlier, we cited Fed estimates that every 10% increase in student debt per person results in a 1 percentage point drop in the homeownership rate for the first five years after graduation. The economy-wide homeownership rate has fallen by 5.5 percentage points since the beginning of 2007, reaching 62.9% in the second quarter of 2016. We estimate that rising student indebtedness could account for as much as 1½ percentage points of the total 5½ percentage point drop. This is based on the Fed's estimates, the rise in the share of student loan borrowers among the total number of households and the increase in student debt-per-person. Again, this estimate likely overstates the impact because we are implicitly assuming that every new student borrower since 2007 ultimately forms a new household upon graduation. Undoubtedly, a portion of student borrowers formed a household with other student borrowers. Even if this estimate is close to the truth, it is not clear that there is a large impact on GDP growth. The formation of new households will result in an expansion in the housing stock one-for-one (assuming no change in inventories). Whether they decide to rent or buy, this will boost the residential investment portion of GDP. Buying a home or condo often results in home renovation and purchases of new furnishings, thus providing the economy with a larger boost compared to new households that rent. Nonetheless, the difference is difficult to estimate and is probably small enough to ignore. Another way to approach the issue is to gauge the impact on the housing market of the greater propensity of 18-35 year olds to live with their parents. Those living at home jumped from 19.2 million in 2007 to 23.0 million in 2015. The proportion of those living at home of the total population of 18-35 year olds rose from 28% to 32%. If the ratio had not increased over the period, it would have resulted in an extra 2½ million young people leaving home. If we assume that one-quarter of them move in with someone else who is also leaving home, then it would result in an increase in the housing stock of more than 1.8 million units since 2007 (condos or single family homes). We estimate that the resulting boost to residential construction growth would have added an average 0.14 percentage points to real GDP growth each year since 2007. Of course, it is not clear how much of the "living at home" trend is due to student loans as opposed to low earnings or poor job prospects. This estimate thus overstates the direct impact of student loans on the housing market. Nonetheless, it is instructive that the living-at-home phenomenon has been a non-trivial drag on economic growth via new home construction. (3) New Business Creation Academic research has also linked rising student indebtedness to a slower pace of new business creation. Research by the Federal Reserve Bank of Philadelphia points out that approximately 60% of new jobs in the private sector are created by small business.14 The U.S. Small Business Administration states that small firms receive approximately three-quarters of their capital needs in the form of loans, credit cards and lines of credit, which often have a personal liability attached. Having student loans reduces one's debt capacity and thus the ability to obtain small business loans. The Fed study compared student loan data and new business formation across U.S. counties. The Fed estimates that an increase of one standard deviation in student debt results in a decrease of 70 in the annual pace of new small business creation, representing a decline of approximately 14½%. Chart II-12 shows the inverse correlation between student debt and new business formation across U.S. states. Chart II-12Student Debt Hinders Small Business Creation The impact of a slower pace of new business creation on overall economic growth is unclear. A student that does not create a new business for whatever reason will likely end up working for an already existing company that is growing, expanding the supply side of the economy anyway. True, small businesses create a lot of jobs, but they lose a lot too because the failure rate for these firms is high in the early years. Some claim that the less vibrant new business environment since 2007 reflects a less dynamic economy, helping to explain the dismal productivity record since that time. However, this flies in the face of the fact that the small business sector is less productive overall than large businesses. Chart II-13 demonstrates that there is a rough correlation between the new firm creation rate and real GDP growth per capita at the state level. However, it is not clear which one is driving the other. Our sense is that, while a less vibrant new business backdrop likely contributed to the poor post-Lehman economic record, it is far from the major driving factor. Chart II-13GDP Growth And Small Business Creation: Which One Is The Driver? (4) The Federal Budget Could the surge in delinquency rates wind up costing the taxpayer a bundle? Eighty percent of all student loans are either made directly by or are backed by the federal government, generating a potentially large contingent liability. Fortunately for the taxpayer, the recovery rate on student loans is extremely high. Moreover, the Federal government makes money on the spread between the student loan rate and the rate at which it finances these loans (Treasury yields). Congress sets the loan rates and they are kept well above Treasury yields. Under Congressional accounting rules, the cost of a student loan is recorded in the federal budget during the year the loan is disbursed, taking into account the amount of the loan, expected payments to the government over the life of the loan, and other cash flows, all discounted to the present value using interest rates on U.S. Treasury securities. By this accounting rule, the Congressional Budget Office estimates that the Federal government will make a net profit of almost $200 billion over the 2013-2023 period.15 However, a more reasonable "fair value" accounting method, which includes the costs of collection and other items, shows that the student loan program will cost the taxpayer roughly $100 billion over the same period. Either way, the bottom line is that the student loan program is at worst only a minor drain on the Federal government's coffer. Delinquency and default rates are likely to moderate in the coming years. But even if default rates were to surge to new highs for some reason, the recovery rate is so elevated that the impact on the Federal budget balance would be lost in the rounding. Conclusion It seems clear that incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. There has been a vicious circle in which increased federal loan limits supported institutions' ability to raise tuition fees, resulting in a greater need for federal loans. Some for-profit institutions have been criticized for offering shoddy education, for graduating too many students in disciplines for which job prospects are poor, and for encouraging students to load up on high-cost debt. The U.S. spends almost 80% more per pupil on higher education than the OECD average, and yet some argue that this has not resulted in better educational outcomes. The social impact of student leveraging is clearly negative. The benefits of education have narrowed relative to the costs. Financial stress has increased along with debt service burdens, especially for non-traditional borrowers, and repayment periods have been extended to an average of over 13 years. These trends have caused young people to delay marriage and home purchases. This is a serious political and social issue that needs to be addressed. That said, we do not agree with Ms. Bair that student debt is the next "subprime" crisis. Delinquency and default rates are likely to fall in the coming years. These loans have not been packaged into opaque financial instruments and distributed throughout the investment world. The vast majority of the loans are federally backed and the recovery rate is very high. Even if there is a wave of mass defaults, the federal deficit might rise slightly but there is no channel through which the shock can propagate through the financial system. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Mark McClellan Senior Vice President The Bank Credit Analyst 1 "Student Debt and the Class of 2015," Annual Report of the Institute for College Access & Success, October 2016. 2 Beth Akers and Matthew Chingos, "Is a Student Loan Crisis on the Horizon?" Brown Center on Education Policy at Brookings, June 2014. 3 Adam Looney and Constantine Yannelis, "A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults," Brookings Papers on Economic Activity, Fall 2015. 4 Most federal student loans are at a fixed rate set by Congress. 5 Brookings (2015). 6 http://www.edcentral.org/edcyclopedia/federal-student-loan-default-rate… 7 The data are only available to 2010, but we have estimated figures to 2013. 8 Brookings (2014). 9 Brookings (2014). 10 Student loans generally have a 10-year term, but loans consolidated with the federal government are eligible for extended repayment terms based on the outstanding balance, with larger debts eligible for longer repayment terms. 11 "Young Adults, Student Debt and Economic Well-Being," Pew Research Center, May 14, 2014. 12 Daniel Cooper and J.Christina Wang, "Student Loan Debt and Economic Outcomes," Federal Reserve Bank of Boston, October 2014. 13 Alvaro Mezza, Daniel Ringo, Shane Sherlund and Kamila Sommer, "On the Effect of Student Loans on Access to Homeownership," Finance and Economic Discussion Series of the Federal Reserve Board. 2016-2010. 14 Brent Ambrose, Larry Cordell, and Shuwei Ma, "The Impact of Student Loan Debt on Small Business Formation," Federal Reserve Bank of Philadelphia Working Paper, July 2015. III. Indicators And Reference Charts Equity markets ended the month slightly lower as investors come to grips with the economic and profit implications of the pending Fed rate hike and Brexit. While TINA is still in play, caution abounds, as highlighted by waning investor sentiment and continued weakness in our Equity Technical indictor. Rising bond yields and a stronger dollar contributed to a weakening in our Monetary Indictor, trends that no doubt contributed to the overall diminished appetite for risk over the month. Our Equity Valuation Indicators have improved somewhat, but still remain in overvalued territory. Net earnings revisions have become constructive and positive earnings surprises increasingly outpaced negative ones. Despite this, we would need to see a close to 10% price depreciation for U.S. equities to appear attractive, as outlined in Section 1. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. At the moment, the low levels of the WTP indicators suggest that flows have been stronger into bonds than into stocks. From a contrary perspective, this means that there is "dry powder" available if investors decide to move more aggressively into equity markets. The U.S. and Eurozone indicators appear to have bottomed out last month and continue their ascent. This should be bullish for both U.S. and Eurozone equities. The U.S. dollar notched a strong month with a gain of more than 3%. This has tightened financial conditions as can be seen in the decline of our Financial Conditions Index. The deviation from its 12-month moving average is even more pronounced, turning negative after several months of treading water in "easing" territory. Our Dollar Composite Technical indicator displayed a violent move higher, but has yet to breach a level consistent with previous episodes of overextension; the USD can rally further. The yen is showing signs of entering an extended period of depreciation. Net speculative positions are extremely elevated and the 40-week rate of change appears to have formed a trough, rebounding from all-time lows. In a similar vein, the euro is also displaying weakness as its 40-week rate of change is crossing into negative territory. As outlined in Section 1, we expect a 10% appreciation in the U.S. dollar, a 10% depreciation in the yen and a 5% depreciation of the euro in trade-weighted terms. The commodity complex ended the month flat, with a more robust global growth backdrop offsetting the negative impact of a strong U.S. dollar and higher rates. While the advance/decline line ticked up, a positive sign for a potential broad-based gain across currencies, gold had a less than stellar month. The outsized impact of financial variables (U.S. dollar strength and higher real rates) on the yellow metal led to a more than 5% price decline. Our Commodity Composite Technical Indicator surged deeper into overbought territory, indicating that it might be time to take some risk off the table. The balance of risks for commodities excluding oil is to the downside. As mentioned in Section 1, an appreciating U.S. dollar and elevated yields will eventually feed through to weakness in the space. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-19Euro Technicals Chart III-20Euro/Yen Technicals Chart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China
Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper Chart 2European Inflation Is Stubbornly Low The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down Chart 4Inflation Expectations Will Stay Low Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields Chart 7ECB Needs To Keep The Monetary Base Growing As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit Chart 11Lowering The Yield Floor For QE Makes Sense Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 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
Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that 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. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... Chart 4...Outside Of Consumer Spending Chart 5Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact Chart 8TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... Chart 2... And Rising Costs... Chart 3... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease Chart 5Inflation Gap Should Narrow Chart 6Sales Set To Stabilize... In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 Chart 8End Of Foreign Drag Chart 9Still Not Dirt Cheap Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell Chart 11Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights The path of the least resistance for the U.S. dollar is up; this has far-reaching implications for monetary policy, global growth dynamics and asset prices. Dollar strength reinforces our view to overweight defensives vs. cyclicals and is a headwind to overall S&P 500 profits. Most of the gap between core CPI and core PCE can be explained by the medical care component. Overall, core PCE is likely to reach 2% over the next several months; a strong dollar means core goods PCE deflation will be sustained, but rising wage costs will put upward pressure on service sector inflation. Feature Amid the ongoing U.S. elections and Q3 earnings uncertainty, one of our higher conviction views is the likelihood of U.S. dollar appreciation. Our reasoning is straightforward: interest-rate differentials are the strongest 12-18 month predictor of currency trends,1 and relative economic performance between the U.S. and the rest of the world suggests that the gap between U.S. monetary policy and elsewhere will stay wide, and perhaps even widen (Chart 1). Chart 1Interest Rates And The Dollar Moreover, as we showed last week, the trade-weighted dollar provides good insurance against a variety of downside equity risks, even when a financial calamity occurs on U.S. soil. We remain dollar bulls. However, that does not mean that the outlook is without risk. The implications of further dollar strength are wide-ranging: How does dollar strength impact inflation expectations and monetary policy? How does the rest of the world cope with a rising U.S. dollar? How does the S&P 500 stand up to further dollar appreciation? Monetary Policy And The Dollar We have discussed the ramifications of the Fed Policy Loop, the interplay between Fed policy and financial conditions, since September 2015 (Chart 2). Since last year, each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a sell-off in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats itself. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. For example, the ECB and BoJ continue to try to find ways to stimulate their economies, while the Fed is gearing up for a second rate hike. The point is that this feedback mechanism means that monetary conditions tighten in the form of a rising dollar, even without the Fed hiking interest rates by very much (Chart 3). The implication for investors is also clear: for equities, even though overall monetary conditions can tighten, rate-sensitive, domestically-exposed sectors such as telecoms can still perform well, because the tightening is coming mainly through the currency, rather than interest rates. For bonds, the policy loop means that sell-offs are likely to happen in fits and starts: the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because their actions are being exaggerated by movements in the dollar. This is one reason why we are not more eager to move aggressively underweight duration. Chart 2The Fed Policy Loop Chart 3Dollar To Do The Fed's Lifting? ROW And The Dollar Dollar strength, in the context of a robust U.S. economy, can be a good thing for some parts of the world. For example, a strong dollar means that European and Japanese exports will be more competitive. In this benign context, currency strength acts a growth re-distributor, taking growth away from the U.S., but transferring it to others, where the currency has been devalued. Our concerns focus squarely on emerging markets. Since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (Chart 4). Chart 4EM Stocks Don't Like Dollar Strength It is significant that financial markets panicked in August, 2015 when the RMB was devalued by 2% ahead of the Fed's warning about a rate rise, and amid broad based U.S. dollar strength. True, the RMB has weakened periodically since then, without any real fallout for risk assets. Nonetheless, it is hard to say that the global economy - and China for that matter - is in significantly better shape than when the Fed began televising the last rate hike. We do not offer a forecast on the likelihood of further RMB devaluation. However, recent history is a reminder that dollar strength risks creating volatility in global markets. The latter would be especially true if worries about the EM credit cycle resurface. S&P 500 And The Dollar In the last major dollar bull market (1994-2002), U.S. stocks strengthened alongside the rise in the currency, offering some historical support that dollar strength does not necessarily hinder stock market performance. However, the global backdrop during that era was distinctly different from today. During the last half of the 1990s, the entire global economy experienced a supply-side, disinflationary expansion and credit binge. The U.S. was at the forefront of that expansion, and pulled the rest of the world (ROW) along for the ride. In other words, the U.S. and ROW were all moving broadly in the same direction. Today, the global economic backdrop is starkly different. Europe, Japan and China are all battling deflation and the major distinguishing trait of this business cycle is deficient demand and the need to de-lever. As we highlighted above, the U.S. has embarked on a gradual rate hike path, but most other central banks are trying new ways to reflate. In this world, currency movements act to re-distribute growth: a stronger currency can become a headwind to externally sourced profits, rather than a reflection of strong domestic demand. Indeed, the S&P 500 may become even more vulnerable to dollar strength: globally sourced profits as a share of overall S&P 500 profits has been in a steady climb over the past twenty years. Chart 5 shows that net earnings revisions are especially sensitive to currency moves, suggesting that further dollar appreciation would undermine already very lofty earnings expectations and would be a headwind for the broad market. Chart 5Beware The Dollar Drag From a sector perspective, dollar strength has already become problematic and is a main reason why we continue to advocate for defensive stocks relative to cyclical plays. Our U.S. Equity Strategy service published a Special Report on this topic last week.2 The Report outlined a seven item checklist of factors needed before tilting positions in favor of cyclicals. The first item on the list is dollar weakness. The full checklist is here: Chart 6Stick With Defensives Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Most of the items remain unfulfilled and our U.S. equity strategists believe that over the past several weeks, a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist (Chart 6). The bottom line is that the U.S. dollar's path of least resistance is to trend higher. Dollar strength has already become restrictive for some U.S. industries, and unlike the late 1990s, we are concerned that further currency appreciation will act to restrain profit growth, rather than be reflective of a stellar domestic backdrop. Still, the Fed and other central banks' actions have proven to so far be a powerful antidote to earnings concerns: as long as the liquidity taps remain open, investors are willing to look through profit disappointment. We continue to recommend benchmark weightings to equities, but are highly attuned to this profit risk. What Is The True Inflation Rate? The Fed's target is 2% inflation. Core CPI has been above this rate for eleven months, implying that if the Fed's target was based on this measure, policymakers would have been much more aggressive in hiking interest rates. But the Fed's preferred measure, core PCE, is still stuck below the target. The CPI and PCE usually move together. The correlation between the two series is about 98% and divergences tend to be short-lived (Chart 7). Thus, the choice between the two series is often irrelevant, although the recent gap raises an issue for the Fed and the bond market: which measure is currently telling the right story? First, there are many alternative measures of inflation and in Chart 8, we show a selection of them. The median CPI uses the middle or median price change as its estimate of the underlying rate of inflation, irrespective of its share of the overall basket. The trimmed mean CPI removes the most volatile components of the index. The market-based PCE measure of inflation addresses concerns about using "imputed" prices (such as financial services furnished without payment) by leaving them out. Incidentally, this latter series, which is currently somewhat weaker than core PCE, is giving a similar inflation signal to our corporate price deflator. Together, these two measures suggest that the business sector is faced with a much tougher pricing backdrop than the core PCE and core CPI suggest. Chart 7Core CPI And Core PCE Usually Say The Same Thing Chart 8Various Alternative Measures Unfortunately, none of these alternative measures offer reliable leading information and do not help in understanding the divergence between core CPI or core PCE. However, understanding how the indexes are constructed does uncover important differences. Core CPI And Core PCE Explained The core CPI is a fixed-weight index while the personal consumption expenditure is chain-weighted. A fixed-weight index uses a constant basket of goods and tries to determine how much more an individual pays for an identical basket today versus a base year. A chain-type index measures how much it costs to a constantly evolving basket. The latter should be more representative of consumers' evolving buying habits. Historically, the different weighting methodology explains most of the gap between CPI and PCE inflation rates. The remainder of the gap is accounted for largely by the difference in the size of the weights used for the medical and housing components. Housing accounts for 40% of core CPI and only 17% of core PCE. Medical care accounts for 7% of core CPI versus 18% of core PCE. Currently, the gap between core PCE and core CPI is mostly explained by the medical care component (both the relative weights, but also the underlying prices used). In the CPI, only the portion that consumers spend on health care is taken into account, but the PCE also includes the amount that government agencies spend on consumers' behalf. The pricing information on the government funded portion is estimated from the PPI, which sometimes gives a different signal than the data supplied to the CPI from the consumer expenditure survey. The gap between medical care PCE and CPI has become particularly pronounced in the past few years. There is a lot of confusion about what is driving the spike in CPI medical care costs, with some pundits trying to find a political angle. Some blame higher insurance rates, while others blame drug costs. In fact, as Chart 9 shows, all elements of medical care CPI have contributed to the surge. Meanwhile, core PCE shows that medical care inflation has in fact been contained, some say, due to the enactment of the Affordable Care Act (a.k.a. Obamacare). It is not clear that this is the full story and forecasting future rates of inflation specifically in this sector is beyond the scope of this report. Over the next six to twelve months, we would expect some convergence between the two inflation gauges, as CPI medical care inflation peaks. More specifically, we would not be surprised to see the core PCE move slightly above 2%, but we think it is unlikely that much of an overshoot of the Fed's target can occur. Chart 10 shows the major components of CPI and we note the following: Chart 9Medical Care##br## Inflation Is Tricky Chart 10Major Components Of##br## Inflation At Crosscurrents Goods prices continue to fall. If our strong dollar view proves correct, deflation in this sector may persist for years. Recall that throughout the economic recovery in the first half of the previous decade, core goods price deflation persisted; that was during a dollar bear market. This time, dollar strength is likely to keep an even tighter lid on imported prices. Non-shelter service price inflation appears to be rolling over, after a surge earlier this year. The key for core service price inflation is wage pressures, since labor costs are the most significant input cost to U.S. service businesses. For core service price inflation to sustainably break above 3%, i.e. to return to the pre-Great Recession range, recent wage trends will need to be sustained, if not accelerate. Shelter prices are the most difficult segment to forecast. Our model for shelter inflation has flattened out, owing to a decline in market-tightness in multi-family properties. A reasonable working assumption is that shelter inflation stays around 3%, which is roughly the rate of shelter inflation that persisted prior to the housing bubble of the previous decade. Adding it up, core inflation is likely to drift gradually up: service sector inflation will likely trend higher with wage growth, but deflation in the goods sector will provide somewhat of an offset. The Fed has initiated interest rate hikes in the past when core PCE was under 1.5%, so there is historic precedent for policymakers to hike rates before the 2% target is achieved. Of course, this cycle is very different and there has been much talk of the need for policymakers to err on the side of ease for even longer, i.e. allow inflation to run much higher than 2%. Recent Fed communication suggests that a December rate hike is most likely, unless the data significantly worsen in the meantime. Thereafter, if our inflation view is correct, the Fed will find little reason to hike more than twice in 2017. Note: Last week, I had the pleasure of participating in our Geopolitical Strategy service's webcast on the upcoming U.S. Elections. In addition to a well-rounded debate on the U.S. political situation, we also discussed the present economic and investment landscape. To listen to the replay, please go here: www.bcaresearch.com/webcasts/index/131 Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Special Report "Defensive Dominance Has Bent, But Will Not Break", dated October 17, 2016, available at uses.bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical and monetary components of the equity model are still favorable, the earnings-driven component continues to warn that profits are likely to remain lackluster, especially relative to expectations. The allocation for a slight overweight in Treasuries continues to be supported by all three components of the bond model: valuation, cyclical and technical. While the valuation component continues trending towards expensive territory, a "buy signal" still exists for now. The cyclical and technical components of the bond model have retraced some of their bullish signals, but both still maintain a preference for Treasuries, especially relative to cash. Chart 11Portfolio Total Returns Chart 12Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Market Calls