通貨
Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Chart 4...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar
Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Chart 5Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. Profit growth has accelerated at a faster pace than our top-down model had projected and we expect growth to accelerate further into year end. We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth over rest of 2017. Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge. Feature The S&P 500 is attempting to break through the 2400 barrier as we go to press. This is impressive given that the flagging relative performance of infrastructure stocks and highly-taxed companies suggests that investors have given up hope of ever seeing significant tax cuts, infrastructure spending and incentives for capital spending. As we discuss below, disappointment on the policy front has thankfully been offset by solid corporate earnings figures. We believe that investors have gone too far in pricing out tax reform. True, the growing number of White House scandals will serve to delay the GOP's market-friendly policy agenda. Nonetheless, the President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans are on the same page. Capital spending is the part of the economy that could benefit the most from tax reform. Surprising Support From Capex Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. The post-election rollover in C&I loan growth worried investors that rising rates and election-related uncertainty had cut the flow of credit to the business sector, thus putting capex at risk (Chart 1, top panel). That concern was overdone, as we pointed out in a recent report.1 Business expenditures on plant, equipment and software were a surprising source of strength in first-quarter GDP, and bank lending has stabilized in the past six weeks. The FOMC minutes of the May 2-3 meeting noted that "financing conditions for large nonfinancial firms stayed accommodative." The minutes also stated that, while there was weaker demand for C&I loans in April, the weakness "pertained to customers' reduced needs for financing." The reduced need likely reflected a preference to issue corporate bonds. Chart 1Outlook For Capex Looks Solid Our BCA Capex indicator for business investment points to solid business spending in the next few quarters. (Chart 1, bottom panel) Our past research shows that sustainable capital spending cycles only get underway when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were quite soft (+0.3% annualized gain) in Q1, our view is that the weakness was transitory.2 This view was confirmed by the FOMC minutes. A rebound in consumer spending in the second quarter will boost CEO confidence that increased capital spending will be justified in terms of future sales. Our base case is that at least some tax cuts will be enacted by year end, but the risk is that political turmoil further delays a fiscal package or even totally derails the GOP legislative agenda. This scenario would be negative for stocks temporarily, but could end up being positive over the medium term by extending the expansion in the economy and corporate profits. U.S. Profits, Beats And Misses Profit growth has accelerated at a faster pace than our top-down model had projected earlier this year (Chart 2). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at just under 20%, before moderating in 2018. The favorable profit picture reflects two key factors. First, profits are rebounding from a poor showing in 2016, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart 3). Earnings are of course leveraged to corporate sales, helping to explain why profits are highly correlated with industrial production in the major countries. BCA's U.S. Equity Strategy service estimates that operating leverage for the S&P 500 is 1.4x.3 Chart 2Impact Of Stronger Dollar Is Fading Chart 3IP On The Rebound Globally Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row. Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.4 The hiatus of wage pressure may not last long, but for now our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). What About The Dollar? We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth of about one percentage point for the remainder of this year, assuming no change in the dollar from today's level (Chart 2, second and third panels). However, our base case remains that the dollar will appreciate by another 10% in trade-weighted terms. A 10% appreciation would trim EPS growth by roughly 2½ percentage points, although most of this would occur in 2018 due to lagged effects. The key point is that another upleg in the dollar, on its own, should not provide a major headwind for the stock market. Indeed, the dollar would only be rising in the context of robust U.S. economic growth and an expanding corporate top line. Even though the message from our EPS model is upbeat, it still falls short of bottom-up estimates for 2017. Is this a risk for the equity market, especially since valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table 1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in 2008, which was a recession year. But even outside of the recession, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart 4 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years considered. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the direction of 12-month forward estimates (which remains up at the moment). Table 1Bottom Up Estimates Are##BR##Always Too Optimistic Chart 4Oil Related##BR##Dip In 2015 The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. Gold Update Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge against rising inflation and inflation expectations, geopolitical risk and increased equity volatility.5 Chart 5A shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel that it has been in since early 2012 (Chart 5B). There has been a big gap between the model value and the actual price of gold for the past three years. The real price of gold remains elevated despite the fact that inflation has been well contained.6 Chart 5AModel Suggests Gold Is Overvalued Chart 5BIn A Downward Channel Since 2012 Our 6-12 month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year end, just enough to keep the Fed on track this year as it begins to shrink its balance sheet and raise rates two more times. Thus, we do not see a great need to hold gold as a hedge against inflation over the next year. Nonetheless, for those investors concerned about a pullback that turns into a correction or a bear market, we mention that gold has a 33% weight in our Protector Portfolio.7 Chart 6Core Inflation To Stay Near##BR##Fed's Target This Year Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, the yellow metal may have value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Earnings Rebound Will Earn Some Respect", April 10, 2017. Available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation And The Fed", May 8, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," published April 17, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?," published April 24, 2017. Available at usis.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report, "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017. Available at ces.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "Gold: The Asset Allocation Dilemma," published August 1, 2011. Available at usis.bcaresearch.com. 7 Please see U.S. Investment Strategy Weekly Report, "Still Awaiting The Next Pullback," published May 15, 2017. Available at usis.bcaresearch.com.
Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The political theater in Washington has caused the last inning of the dollar correction to materialize. The U.S. economy remains at full employment, growth will stay above trend, and the Fed will be capable of hiking rates by more than the 66 basis points priced into the OIS curve over the next 24 months. It is time to buy the DXY. Investors are too optimistic on the euro and too negative on the CAD, short EUR/CAD as a tactical bet. The Swedish economy continues to improve. Yet, the SEK has limited upside as the Riksbank continues to find excuses to justify its dovishness. The downside for EUR/SEK is limited to 9.3. Feature Chart I-1Trump Rally Is Gone Four weeks ago, we wrote that the U.S. dollar correction was entering its last inning and recommended investors should wait a few more weeks before betting on renewed dollar strength.1 We think the time to bet on this rebound is now. To begin with, the dollar index has now erased all the gains accumulated since Trump's electoral victory, suggesting that all the hope of fiscal stimulus, deregulation, and tax cuts have now been priced out of the greenback (Chart I-1). In fact, at this point in time we think too many risks have been priced into the dollar. For one, the market is overemphasizing the likelihood of a Trump impeachment. While our Geopolitical Strategy group does think the likelihood of an impeachment procedure is near 100% if the democrats win the House in 2018, the likelihood remains much lower in 2017.2 Simply put, Trump remains a very popular president among republican voters (Chart I-2). Most problematic for many republicans that would like to see Trump out of office, is that his popularity is particularly strong among the "Tea Party" districts and voters (Chart I-3). Chart I-2Trump Still Popular With Republicans Chart I-3Trump Is Popular In Tea Party Territory Second, the chance that tax cuts are part of the upcoming budget negations is high. Tax cuts are espoused by the entire GOP caucus. Additionally, Republicans know that in order to avoid losing the Senate or the House of Representatives, or both, they have to do something popular with voters. Tax cuts definitely fit the bill. This simple political assessment points toward a likely passage of stimulus in the coming quarters despite Trump's personal woes. Finally, if Trump were to be stabbed in the back by the GOP establishment, what would the impact be on the dollar? Would the U.S. default? No. Would the economy enter a recession? No. Would the Fed become dovish? Neither. If anything, a potential removal of Trump from the oval office reduces the risk that he appoints a super-dove at the helm of the Fed, a risk that would have been very negative for our positive dollar cyclical stance. Regarding the economics behind the dollar rally, our positive cyclical stance on the USD predates the election of Trump, and in fact relied on the underlying shifts in the U.S. economy.3 These dynamics are still intact: While wage growth remains anemic, this partly reflects the fact that the long-term determinant of wage growth, productivity growth, is low. When this is taken into account, productivity-adjusted wage growth is in line with levels that in the past have prompted the Fed to tighten policy in order to combat potential inflationary dynamics (Chart I-4). Nonetheless, the risk is that wages begin accelerating going forward. The labor market is at full employment, with the U-3 unemployment rate standing 0.3 percentage points below the Fed's estimate of the neutral unemployment rate. Additionally, hidden labor market slack has also greatly dissipated (Chart I-5), with the U-6 unemployment rate, the number of workers in part-time jobs for economic reasons, and the amount of workers outside of the labor force but that would still like to have a job if economic conditions warranted it all back to levels where historically wage growth has gained momentum. Chart I-4Without Productivity Gains, Current Wage##br## Growth Is Enough For A Tighter Fed Chart I-5U.S. Labor Market##br## Is Tight Moreover, the outlook for consumption remains sturdy. Overall household income growth remains supported by elevated levels of job creation, and our indicator for real household disposable income growth continues to point up. Additionally, Federal income tax withholdings are accelerating, a sign of more robust consumption to come (Chart I-6). With consumer confidence at 17-year highs, positive income developments are likely to be translated into consumption. The outlook for capex is also bright. CEO confidence and capex intentions have all rebounded sharply, moves whose genesis predate Trump's election (Chart I-7). Moreover, elements are in place for these positive feelings to be catalyzed into actual investment. On the back of rebounding revenue growth, thanks to nominal GDP growth exiting levels historically associated with recessions, profit growth will receive a fillip, which should boost capex in the current context (Chart I-8). Chart I-6Income Tax Receipts Points ##br##To Healthy Consumption Chart I-7Capex Intentions Point ##br##To Higher Growth Chart I-8Revenue Growth Exiting ##br##Recessionary Levels Finally, when all major indicators are aggregated, real GDP growth looks set to accelerate. BCA's Beige Book diffusion index, based on the distribution of positive and negative mentions about the state of the economy in the Fed's Beige Book, is pointing to an acceleration in activity (Chart I-9). This suggests that the collapse in U.S. economic surprises may be toward its tail end. With this in mind, we continue to expect the Fed to increase rates more than the 66 basis points currently anticipated in the OIS curve over the next two years, as such, this supports our bullish stance on the dollar. In terms of tactical developments, the recent selloff has brought the DXY toward the levels congruent with the end of the correction.4 Additionally, based on our Intermediate-term timing model, the USD is now cheap enough to justify taking a long bet on the currency. The deeply oversold levels reached by our Intermediate-term momentum oscillator supports this message (Chart I-10). Finally, the Swedish Krona seems to be confirming these signposts. USD/SEK has historically displayed one of the strongest betas to the trade-weighted dollar's movements. The fact that this pair has not been able to break down below a long-term upward slopping trend line put in place since 2014, and that it also managed to stay above its 2015 peaks, gives us more confidence that the dollar correction is likely to have run its course (Chart I-11). Chart I-9BCA's Beige Book Monitor ##br##Improves Growth Will Strengthen Chart I-10Dollar Is ##br##Oversold Chart I-11USD/SEK Giving A Hopeful##br## Signal For DXY Bottom Line: The dollar has taken a beating in the wake of the scandals emerging out of the White House. In our view, these developments were only the catalyst that crystalized the last leg of the USD correction that begun in late 2016/early 2017. Ultimately, the bull case for the dollar predates Trump and rests on the dissipating slack in the U.S. economy. These developments are intact, even with Trump's fiascos in the foreground. Tactically, the dollar is now cheap enough and oversold enough to justify investors buy the DXY again. We are opening a long DXY trade this week. We remain long the dollar against most commodity currencies and EM currencies. The yen may continue to benefit if the budding weaknesses in the EM space gather further momentum. EUR/CAD Is A Short At this juncture, it would be natural for us to begin shorting the EUR against the USD. In fact, we believe the recent spike in the EUR has created a good shorting opportunity against the European currency. While we worry investors are becoming too pessimistic on the U.S., we believe investors are too optimistic regarding the capacity of the ECB to increase rates. Investors moved away from deep short positions on the euro and are now net long this currency. Also, while in July 2016 investors expected the first ECB rate hike to materialize in more than five years' time, they are now expecting the first repo rate hike to happen in just 24 months (Chart I-12). This looks premature. For comparison's sake, in the U.S. we are only seeing the early signs of labor market tightness, despite the last recession ending in the summer of 2009. Europe was victim to a double-dip recession, the last leg of which ended in 2013. This decreases the likelihood of Europe being at full employment today. More concretely, there remains plenty of hidden labor market slack in the euro area. In Europe, the main form of slack exists among workers hired under contracts, contracts that do not offer the same level of benefits and protections as regular employment. The euro area increasingly has a dual labor market, a condition that has weighed on wage growth for more than two decades in Japan. Today, as a result of such dynamics, the level of labor underutilization in Europe is still very elevated, which will continue to limit wage growth going forward (Chart I-13). Hence, core inflation dynamics in Europe are likely to prove disappointing and they will keep the ECB on a more dovish path than investors currently appreciate. Chart I-12Investors Too Optimistic On The ECB Chart I-13Labor Market Slack In The Euro Area Remains High For now we are electing to profit from this view by tactically shorting the euro against the CAD. We do believe there are problems in Canada, a topic we discussed a few weeks ago.5 But at this juncture, these worries seem well digested by markets. The Home Capital Group debacle has been front page news for weeks, but the aggregate banking sector remains strong, especially as loses on the mortgage holdings of Canadian banks will ultimately be passed on to the government through the insurance provided by the Canadian Mortgage and Housing Corporation. Additionally, in the wake of the deepening trade dispute on softwood lumber, the fears of a disintegration of NAFTA have hit Canada especially violently, with the CAD falling 16% against the peso since January 2017. Chart I-14EUR/CAD Is Toppy Tactically, the pieces are falling into place to favor the CAD over the EUR. Our Commodity and Energy group remains positive on the outlook for oil prices. The continuation of the output controls by OPEC and Russia remains binding as oil producers want to further curtail elevated oil inventories. Therefore, oil prices have little downside and may even experience further upside, helping the CAD in the process. Additionally, investor positioning is very skewed. Investors are massively short the CAD, especially when compared to the euro, which historically has provided a signal to short EUR/CAD (Chart I-14). This is re-enforced by our Intermediate-term technical indicator which shows EUR/CAD as massively overbought. Shorter-term momentum measures such as the RSI or the MACD have also been forming negative divergences with actual prices in recent days. Bottom Line: The euro is likely to suffer if the USD correction is indeed finishing. Hidden labor market slack remains a much deeper problem in Europe than in the U.S. and will limit the capacity of the ECB to increase rates in the next two years, as investors are currently expecting. For now, we are electing to short the euro against the CAD instead of against the USD. The Canadian dollar is oversold and oil prices have limited downside from here as supply adjustments remain positive. Moreover, investors are at record shorts on the CAD, especially when compared to the euro. Sweden Is Strong, But The Riksbank Still Haunts The SEK The long-term outlook for both Sweden and the Swedish krona remain bright but the ultra-dovish stance of the Riksbank remains a potent short-term hurdle. To begin with, the SEK offers great value. Not only is it trading at 24% and 8% discounts to its PPP fair value against the USD and the EUR, respectively, but the trade-weight SEK is also trading at a near one-sigma discount against our long-term fair value models (Chart I-15). Chart I-15SEK Is Cheap... But Is It Enough? Additionally, Sweden's net international investment position has moved back in positive territory in 2014, and now stands 16.4% of GDP (Chart I-16). This is not only a reflection of the weakness in the SEK since 2014, but is first and foremost the end-result of more than two decades of accumulated current account surpluses. This development is crucial. Not only does the positive income balance generated by assets in excess of international liabilities put a floor under the current account; historically, currencies with positive and growing net international investment positions tend to exhibit an upward bias. In terms of economic developments, employment growth in Sweden remains steady. Unemployment has been in a protracted downtrend, falling 2.9 percentage points since 2008 (Chart I-17). Yet, despite being well into full employment territory, wage growth has been absent. To a large degree, this reflects entrenched deflationary pressures in the Swedish economy. However, deflationary forces are abating. Chart I-16A Long-Term Driver Pointing North Chart I-17Swedish Labor Market At Full Employment To begin with, Sweden's output gap has recently entered positive territory, which historically has been a reliable indicator of inflationary pressures in this country (Chart I-18). Also, monetary aggregates, M1 in particular, continue to point toward higher inflation in Sweden. This means that with the employment market being at full capacity, the conditions for higher inflation in Sweden are emerging. Our expectation of an upcoming upturn in the Swedish credit impulse - which until now has been contracting and exerting deflationary forces on the economy - reinforces confidence in our inflation view. Credit growth tends to lag industrial activity, but our industrial production model for Sweden is perking up. Improving industrial variables suggest that credit will move from depressing demand back to supporting demand, further rekindling inflationary forces (Chart I-19). Chart I-18Swedish Inflation Is Set To Pick Up Chart I-19Swedish Credit Impulse Will Rebound With this positive backdrop for prices, should investors buy the SEK right now? The Riksbank continues to represent a great hurdle for SEK bulls. The Swedish central bank has one of the strongest dovish biases amongst global monetary guardians. Against expectations, it recently increased the duration of its asset purchase program, giving markets a strong signal that it is unlikely to increase rates soon. This means that the Riksbank is unlikely to tighten policy until it sees the "whites of inflation's eyes". While we are moving in the right direction, we are not there yet. Officially, the Riksbank targets CPIF, which currently clocks in at 2%. Yet, the emphasis of the central bank on domestic price dynamics implies that adjustment away from dovishness will only occur when core inflation itself moves to 2% (Chart I-20). This means that gains in the SEK will be limited. To begin with, EUR/SEK does have downside, and our view that the euro is getting overextended highlights that EUR/SEK could fall toward 9.3. However, beyond this level, gains should prove limited as Sweden is a small open economy and EUR/SEK plays a big role in tightening monetary conditions for that country. As a result, any move in EUR/SEK below 9.3 is likely to be unwelcomed by the Riksbank until core inflation moves closer to 2%. Versus the USD, it will be even more difficult for the SEK to rally. Historically, the SEK has been one of the most sensitive currencies to the dollar's trend, implying that strength in DXY could be magnified in USD/SEK. In fact, the absence of breakdown in USD/SEK in the face of violent dollar selling pressures this week suggests that the SEK could be a serious casualty of a rebounding dollar. Additionally, real rate differentials continue to move in favor of the U.S. dollar, with U.S. 2-year real rates now 180 basis points above that of Sweden (Chart I-21). With the Intermediate-term technical indicator for USD/SEK now hitting oversold levels, the downside for USD/SEK is very limited, further supporting the idea that any rebound in DXY could lead to significant weaknesses in SEK. Chart I-20Core Inflation Needs To Rise Chart I-21Rates Differentials Support A Lower SEK Bottom Line: The Swedish economy has adjusted and several factors are pointing toward a pickup in core inflation in the coming quarters. However, the Riksbank has maintained a strong dovish bias. We need to see an actual pick up in core inflation itself before the central bank moves away from its dovish bias. While EUR/SEK could weaken toward 9.3, more gains for the krona against the euro will prove elusive until the Riksbank sees firmer inflation. USD/SEK is a buy at current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “Break Glass In Case Of Impeachment”, dated May 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled “Dollar: The Great Redistributor”, dated October 7, 2016, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report titled “AUD and CAD: Risky Business”, dated March 10, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The past week has been quite eventful for the greenback, slipping almost 2.3%. Most of the downside is owed to markets revising down rate expectations, on the basis of weak growth numbers and political scandals. The 10-year yield dropped, gold rose, and equities fell. There was also a large sell-off in EM currencies and a sharp appreciation in the yen. Furthermore, the soft patch in U.S. data continued as housing starts and building permits came in especially weak in April: 1.172 million and 1.229 million respectively, both underperforming consensus. Nevertheless, markets calmed after the release of stronger employment numbers with initial and continuing jobless claims beating expectations. The upswing in the Philly Fed index also helped revive sentiment. The dollar picked up Thursday morning following these releases. Interestingly, the DXY is at pre-election levels, which suggests that the dollar is nearing its bottom. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro has enjoyed significant upside as a result of Macron's victory and the dollar's drubbing. Weak data in the U.S. caused markets to revise growth expectations, pressuring the dollar downwards and the euro up. Further lifting the euro were comments by ECB President Mario Draghi, who highlighted that growth in the euro area is performing well. However, he also reiterated that "it is too early to declare success". These forces have lifted the euro to expensive levels on a tactical basis, suggesting the path of least resistance is most likely down as the ECB will find it hard to tighten policy and the dollar resumes its bull market. Data in the euro area has been mixed as of late without too much disappointment, and inflationary pressured remain unchanged. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 After coming slightly above 114, USD/JPY has plunged by more than 3%, as a result of the market pricing increasing odds that president Trump will get impeached. Although we believe that the correction of the dollar has run its course, the end of the Trump trade might have triggered the sell-off we have been expecting in emerging markets. Thus we like to play this risk off period by shorting NZD/JPY. On the data side, news have mostly been negative: Machinery orders contracted by 0.7% YoY, underperforming expectations. Consumer confidence came in lower than last month at 43.2. Bank lending grew by a measly 3% YoY underperforming expectations. However, real GDP for Q1 came in at 0.5% QoQ, beating expectations. This was dampened by the weak GDP deflator, which contracted by tk%. We continue to be yen bears on a cyclical basis, as the fed will raise rates more than the markets expects, while the BoJ will continue anchoring 10-year yields around zero. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K has been mixed: Industrial Production growth came in at 1.4%, underperforming expectations. However retail sales and retail sales ex-fuel growth came in at 4% and 4.5% respectively, both outpacing expectations. Crucially, both core and headline inflation came above expectations at 2.4% and 2.7% respectively. This surge in inflation is important as it raises the odds of a BoE hike this year, especially as the economy remains resilient. Moreover, as long term inflation expectations continue to be well anchored consumption is likely to continue to surprise as households are looking through the inflation caused by the depreciation in the pound. Overall, we continue to be positive on GBP against all other currencies but the U.S. dollar, given that the British economy will likely stay more resilient than investors are anticipating. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA shed some light on the Australian economy through its most recent Minutes, highlighting that monetary policy needs to remain accommodative to support economic trends. It noted the negative hit to terms of trade as a result of Cyclone Debbie curtailing coking coal exports. China's housing market was also identified as a risk to Australia's exports and terms of trade. Nevertheless, this week the AUD was buoyant, helped by a weaker greenback. However, the factors above paint a bleak picture for the AUD's future. The very important employment figures depicted a similar trend to that of last year, with full-time employment in fact contracting while part-time employment picked up. Unemployment also declined by 0.2% to 5.7%, however, wages remain subdued. This corroborates the weaker core CPI measure of 1.5%, while the strong headline figure of 2.1% is likely to be transitory when the recent commodity-prices weakness kicks in. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ continues to much more accommodative than warranted. The monetary policy report highlighted that the recent surge in inflation is mainly attributable to tradables, and that non-tradable inflation is bound to increase very gradually. We continue to believe that the RBNZ is understating the inflationary pressures in the economy, as core inflation is already higher than 2%. Additionally, retail sales are growing at 10-year high and nominal GDP growth has skyrocketed to 7.5%, by far the highest in the G10. Right now, the market expects the first rate hike to come in 9 months. We believe that a rate hike at this point would be the bare minimum for the RBNZ to avoid an overheating in the economy. Thus expectations have nowhere to go than up and the NZD now has considerable upside against the AUD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been somewhat weaker this past week as oil prices rebounded and the dollar fell. Oil prices are likely to see further upside as OPEC and Russia are likely to agree to another supply cut to support oil prices. Domestically, the economy is improving as unemployment is declining and PMIs are perking up. The BoC also identified the output gap to close earlier than expected in its last meeting. The almost 4% depreciation in the CAD in the past month has made the oil-based currency considerably cheap. When looking at EUR/CAD, the depreciation has been around 7.5%. With the euro now sitting in expensive territory, the ECB is unlikely to change its stance any time soon as inflation has not yet rooted itself, while peripheral economies' inflation remain weak. The CAD, however, is likely to see further upside on the back of increasing oil prices and a strengthening economy. These factors warrant a short EUR/CAD trade. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 And CAD: Risky Business -AUD March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the election of Emmanuel Macron as the new president of France EUR/CHF skyrocketed, coming close to hitting 1.1. At this point EUR/CHF is a very attractive short, given that good news for the euro are likely to tapper now that the French election is behind us. When it comes to inflation, the ECB will likely focus on the lowest denominator, because in spite of higher inflation in some countries like Germany or Austria, inflationary pressures remain muted in most other economies. This will prevent the ECB from tightening monetary policy as fast as the market expects. Meanwhile, the possibilities that the SNB takes the floor off EUR/CHF at the end of this year or the beginning of 2018 are rising given that inflation and economic activity are slowly coming back to Switzerland. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated in the past weeks thanks to the fall in the dollar as well as rising oil prices. Additionally, the fall in inflation is slowing down, with core and headline inflation coming in at 1.7% and 2.2% respectively. Is it time to become bullish on the NOK against the U.S. dollar? We do not believe this is the case. While inflation might be close to bottoming it is unlikely to surpass the Norges Bank target in the coming years, given that inflationary pressures remain muted in Norway. Furthermore, given that USD/NOK is more sensitive to real rate differentials than oil prices, the effect of a dovish Norges Bank on USD/NOK will be much stronger than the impact of rising oil prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 We expect the SEK to experience limited upside in the next 3-6 months. The Greenback is bottoming and we expect USD/SEK to pick up on the back of the dollar bull market. Furthermore, EUR/SEK has limited downside as the RIksbank wants to keep monetary conditions easy. Indeed, the Swedish central bank is also planning to officially target CPIF instead of the CPI. While both of these measures are near 2%, the behavior of the Riksbank suggests that it is in fact targeting core inflation. Core inflation itself is still somewhat depressed, as consumer activity remains weak. However, we expect core inflation to pick up on the back of a higher credit impulse and money supply growth, which should help the Riksbank exit its dovish tilt later this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades