Inflation/Deflation
Highlights Yield Curve & Fed: The yield curve will not invert until inflation has first recovered to the Fed's target. This means that a period of curve steepening is likely, driven either by rising inflation or a more dovish Fed. Corporate Sectors: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Feature Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. [...] The broadly anticipated behavior of world bond markets remains a conundrum. - Alan Greenspan, February 20051 By the end of the week the Fed will have raised interest rates by 125 basis points since December 2015, yet the 10-year Treasury yield has risen only 7 bps (Chart 1). But unlike in 2005, there is no bond conundrum. On the contrary, the reason for low long-maturity Treasury yields is easily understood. Chart 1What Conundrum? Quite simply, the Federal Reserve has been lifting interest rates in-line with its projections for rising inflation, but markets are trading off the fact that this inflation has yet to materialize. The compensation for inflation protection embedded in 10-year yields is only 1.88%. Historically, when core inflation is close to the Fed's 2% target, compensation for inflation protection has traded in a range between 2.4% and 2.5%. Essentially, Fed rate hikes have lifted short-maturity yields but low inflation is keeping long-maturity yields depressed. The result is that the 2/10 Treasury slope has flattened all the way down to 58 bps from 128 bps in December 2015 (Chart 1, bottom panel). What should be clear is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates but inflation fails to rise, then the yield curve will invert in the coming months - a signal that bond investors anticipate a recession - and the Fed will have not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves us with three possible outcomes for Fed policy and the Treasury curve during the next six months. 1) The Fed Is Right In this scenario inflation starts to rebound in the coming months, pushing the compensation for inflation protection embedded in long-dated bond yields higher (Chart 2). This would certainly cause long-maturity nominal yields to increase and would probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates.2 BCA's Outlook for 2018 makes the case for why inflation is likely to bottom in the coming months, and we view the "Fed is Right" scenario as the most likely outcome.3 Chart 2Fed Expects Higher Inflation 2) The Fed Is Proactive In this scenario the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. It therefore proactively adopts a more dovish policy stance to prevent the yield curve from inverting. The likely first step would be signaling a slower pace of rate hikes in this week's Summary of Economic Projections. The yield curve would also steepen in this scenario, but this time a bull-steepening where short-maturity yields fall more than long-maturity yields. At least one FOMC member already seems worried enough to take this sort of action. St. Louis Fed President James Bullard said two weeks ago that: "Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts".4 But other policymakers are less concerned. Cleveland Fed President Loretta Mester downplayed the flat yield curve in a recent interview.5 We view this outcome as the least likely of our three scenarios. With economic growth accelerating (see Economy & Inflation section below), the Fed will likely cling to its forecast that inflation will move higher. If inflation fails to respond, then risky assets will eventually sell off. This brings us to the final scenario. 3) The Fed Is Reactive The Fed does not have a strong track record of proactively responding to low inflation readings, but it does have a strong track record of reacting to tighter financial conditions and risk off periods in equities and credit markets. What's more, if the yield curve continues to flatten, then we are very likely to see credit spreads widen and equities sell off quite soon. At that point the Fed would almost certainly respond by signaling a slower pace of rate hikes. That would steepen the curve and ease the pressure on risky assets. We view this third scenario as more likely than the one where the Fed is proactive. In fact, we observe that the yield curve is already flat enough that the chances of a sell-off in High-Yield corporate bonds relative to Treasuries are high. Using monthly data going back to 1988, we see that a flatter 2/10 Treasury slope is consistent with lower monthly excess returns from High-Yield (Chart 3). We also see that a flatter yield curve is consistent with more frequent risk-off periods (Chart 4). Chart 3Junk Monthly Excess Returns & ##br##Yield Curve (1988-Present) Chart 4% Of Months With Negative High-Yield ##br##Excess Returns (1988- Present) This makes sense intuitively. An inverted yield curve is a well-known recession indicator. This means that when the yield curve is very flat investors are obviously nervous that any new piece of bad news could tip the curve into inversion and signal an end to the economic recovery. In other words, a risk-off episode in junk bonds, like the one witnessed in early November, would be less likely to occur if the yield curve were steeper.6 We would recommend buying the dips on any near-term correction in junk bonds, because the Fed would then be forced to get more dovish and support the credit markets. But unless inflation returns and steepens the Treasury curve from current levels, the risk of just such an episode is high. Corporate Sector Year-In-Review With 2017 nearly in the books, this week we take a quick look back at the performance of the 10 main investment grade corporate bond sectors during the year. Chart 5 shows the excess return for each sector relative to its duration-times-spread (DTS) from the beginning of the year. DTS is a common measure of risk for corporate bonds, and can be thought of much like an equity's beta. When the overall corporate bond market is rallying, then high-DTS sectors tend to perform better. Conversely, when corporate bonds underperform Treasuries, then high-DTS sectors tend to lose more than the low-DTS alternatives. As can be seen in Chart 5, given that 2017 was a risk-on year, high-DTS sectors tended to outperform low-DTS sectors with a few exceptions. The Basic Industry sector and Financials performed much better than their DTS alone would have predicted, while the Communications sector performed much worse than its DTS would have predicted. Looking ahead into 2018, we make the following observations: Excess returns for investment grade corporate bonds are likely to be lower in 2018 than in 2017.7 In turn, this means that the Credit Risk Premium - the extra return earned for taking an additional unit of DTS risk - will also be lower. We calculated the Credit Risk Premium for each year since 2000 by performing a regression of annual excess returns for each of the 10 major sectors versus their beginning-of-year DTS. The beta from that regression represents the additional return earned that year from taking an extra unit of DTS risk. Chart 6 shows that this Credit Risk Premium is an increasing function of excess returns for the overall corporate sector. Logically, if the year ahead is likely to deliver lower excess returns for the overall index, then we should also expect less additional return from increasing the DTS risk of our corporate bond portfolios. Chart 52017 Corporate Sectors ##br##Excess Returns* Vs DTS** Chart 6Excess Returns* Vs ##br##Credit Risk Premium Second, we use our corporate sector model - a model that adjusts each sector's spread by its average credit rating and duration - to identify sectors that have the potential to outperform their DTS in the coming months. This model is updated each month in our Portfolio Allocation Summary.8 The most recent update shows that the high-DTS Energy, Basic Industry and Communications sectors are all attractively valued. The most attractive low-DTS sectors are Financials and Technology (Chart 7). Chart 7Risk-Adjusted Value In Corporate Sectors* Bottom Line: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation Does Consumer Credit Growth Put The Recovery At Risk? Last week's employment report showed a sharp increase in aggregate hours worked and suggests that U.S. economic growth has indeed shifted into a higher gear. We use a combination of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 to get a rough tracking estimate for U.S. real GDP growth. After last Friday's report this proxy is up to a healthy 3.1% (Chart 8). Last Friday's Consumer Sentiment data also suggest that consumer spending, the largest component of U.S. GDP, will stay firm in the coming months (Chart 9). While consumer credit growth has started to slow (Chart 9, panel 2) and consumer delinquencies are starting to rise (Chart 9, bottom panel), we are not yet inclined to view those trends as risks to the economic recovery. Chart 8Growth Tracking Well Above Trend Chart 9Credit Growth Falling & Delinquencies Rising First, notice that prior to the onset of recession, consumer spending growth tends to decline while consumer credit growth accelerates. It is only well after the recession begins that consumer credit growth follows spending growth lower. This chain of events is highly logical. In the late stages of the recovery households first start to see their incomes decline and then turn to credit to support their spending needs. Eventually, banks make consumer credit less available and consumer credit growth also decelerates, but we are already well into the recession by then. Chart 10Bank Lending Standards In fact, judging by the patterns observed in the lead up to the last two recessions, the warning sign for the economic recovery would be if consumer credit growth is rising while consumer spending growth is falling. So far this pattern has not been observed. Potentially more troubling is the increase in the consumer credit delinquency rate. Delinquencies do tend to rise prior to the onset of recession, although at the moment delinquencies are rising off an extremely low base. It is possible that after having kept lending standards very stringent for several years after the Great Recession, an uptick in delinquencies off historically low levels simply reflects a return to "business-as-usual" for banks. In fact, the Federal Reserve's Senior Loan Officer Survey showed a large tightening of consumer lending standards during the crisis, but then a moderate easing from 2010 until quite recently (Chart 10). Further, the most recent Senior Loan Officer Survey showed an increase in banks' willingness to extend consumer installment loans. Historically, this has been associated with falling consumer delinquency rates (Chart 10, bottom panel). Bottom Line: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 For a look at what different combinations of Fed rate hikes and long-maturity yields mean for the slope of the yield curve please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 3 Please see BCA Special Report, "Outlook 2018: Policy And The Markets: On A Collision Course", dated November 20, 2017, available at www.bcaresearch.com 4 https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2017/assessing-yield-curve 5 https://www.bloomberg.com/news/articles/2017-12-01/fed-s-mester-shrugs-off-flattening-yield-curve-in-call-for-hikes 6 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 8 For the most recent update please see U.S. Bond Strategy Portfolio Allocation Summary, "A Higher Gear", dated December 5, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights We are putting the Indonesian stock market on an upgrade watch list. Indonesia's financial markets' beta relative to EM peers has been declining. As such, Indonesian markets will likely outperform the EM benchmark in a sell-off. Inflation in Mexico is peaking and will drift lower. The Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. However, we still recommend that investors maintain a neutral stance on Mexican assets relative to EM peers until more clarity emerges from the NAFTA negotiations. Feature Indonesia: Putting On Upgrade Watch List Indonesian share prices have considerably underperformed the EM benchmark since February 2016 (Chart I-1). This has occurred despite exports growing at an annual rate of 18% in U.S. dollar terms in 2017. The surge in Indonesian exports has been largely driven by soaring prices for thermal coal, palm oil and copper. Export prices have soared by 24% for coal and copper and 11% for palm oil from their lows in early 2016. Nevertheless, their export volumes have been rather stagnant (Chart I-2). These commodities are large drivers of Indonesia's exports. Thermal coal and palm oil account for around 20% of total exports, while copper accounts for around 4%, in value terms. Chart I-1Indonesian Stock Prices: Relative & Absolute Chart I-2Indonesian Exports: Volume Vs. Prices We expect coal1 and base metals prices to drop considerably in 2018 due to China's meaningful growth slowdown. Having this backdrop in mind, we discuss the outlook for Indonesia's stock market in both absolute and relative terms. We continue recommending a neutral allocation to Indonesian stocks within an EM equity portfolio for now, but are putting this bourse on an upgrade watch list and will wait for the following triggers to go overweight: Chart I-3Chinese & Indonesian Equities: ##br##A Rotating Dance The first trigger is when Chinese H-shares and large-cap tech stocks begin underperforming the EM overall equity index. Interestingly, the relative performance of Indonesian equities and Chinese stocks has been negatively correlated (Chart I-3). Indonesia's stock market's underperformance relative to the EM benchmark can be also partially explained by the manic rise in a small number of EM large-cap tech stocks. Tech stocks are absent from Indonesia's stock exchange and when tech stocks' relative performance does turn south, it will be easier for the Indonesian bourse to outperform the EM benchmark. The second trigger for upgrading Indonesian stocks is when the initial phase of decline in commodities prices (10-15%) occurs. This phase could be the most painful for commodities plays like Indonesia, as nervous investors bail out. In short, we are waiting for the momentum of Indonesia's relative performance to turn up before overweighting the bourse. Domestic Demand And Exports: Parting Ways? The Indonesian economy and its financial markets have historically been highly correlated with commodities prices and exports: a positive external shock would trigger an export boom and foreign inflows would ensue. These inflows would in turn lead to currency appreciation and a subsequent fall in interest rates. The end result was the overheating of the economy and financial markets. Recently, however, Indonesia's economy and financial markets have been slowly disconnecting from exports in general and commodities prices in particular. The top panel of Chart I-4 shows that while exports used to be extremely correlated with the rupiah, these correlations have been breaking down since early 2016. Similarly, a disconnect is occurring between exports and other domestic macro variables like bank loans (Chart I-4, bottom panel). What is also noteworthy is the absence of a notable pickup in domestic demand growth amid the strong recovery in global trade. Chart I-5 shows that car and motorcycle sales are still anemic. Chart I-4Disconnect Between Indonesian ##br##Exports Vs. Rupiah & Bank Loans Chart I-5Indonesia's Domestic Sector Remains Sluggish Below are some of the reasons that help shed light as to why this divergence between exports and domestic demand has been taking place: First, the ratio of Indonesia's commodities' exports to total has fallen more sharply than in other commodities-producing EM nations (Chart I-6). Exports have also become generally less important for the overall Indonesian economy post the global financial crisis. Chart I-7 shows that private non-financial debt as a whole has risen, while exports have fallen as a share of GDP. Chart I-6Indonesia's Commodities ##br##Exports Ratio Has Plunged Chart I-7Private Debt Is A Bigger Driver Of ##br##Indonesia's Economy Than Exports The government has been following cautious and prudent policies. This is another reason why domestic demand growth has been mediocre amid robust exports. Chart I-8 signifies that growth in government expenditures has stalled in nominal terms and contracted in real terms. Indeed, the impulse in the banking system's net domestic assets (the combined aggregate of the central bank and commercial banks) remains negative, albeit improving on a rate of change basis (Chart I-9). Net domestic assets (NDA) measure the banking system's2 credit to the domestic sector - i.e. the government and the private sector. Chart I-8Indonesia's Government ##br##Has Been Prudent Chart I-9Banking System's Net Domestic ##br##Assets & Fiscal Deposit Drain The NDA impulse has been negative because the government has borrowed less from the banking system. In addition, the government has been shifting deposits from commercial banks to the central bank (Chart I-9, bottom panel). This has drained liquidity in the system and has slowed broad money growth and capped commercial banks' reserves at Bank Indonesia. As the potential negative term-of-trade shock transpires, the government will have enough of a buffer to spend by deploying its deposits from the central bank and by borrowing and spending more. That will in turn provide support for the economy when commodities prices fall and the external sector suffers. Chart I-10Central Bank Has Been Building FX Firepower As for the currency, the central bank has recently accumulated plenty of foreign exchange assets, creating commercial bank reserves in the process (Chart I-10). The central bank now has plenty of room to defend the currency by selling foreign assets when the rupiah comes under selling pressure. Bank Indonesia will also have more leeway managing a reasonable balance between a depreciating currency and rising local interbank rates. Bottom Line: Indonesia's domestic demand has been mediocre, despite the surge in exports and commodities prices. Meanwhile, the central bank and the government have used the positive global environment to accumulate firepower. This puts them in a position to act as shock absorbers when the external environment turns hostile. As a result, the Indonesian financial markets' beta to their EM peers will decline. We therefore recommend putting the Indonesian stock market on an upgrade watch list. Consistently, the potential downside in the currency and a sell-off in the domestic bond markets will be smaller than we previously anticipated. While still advocating a cautious/neutral stance on this market, we will be looking to upgrade it to overweight versus its EM peers after the first phase of a potential EM and commodities sell-off transpires. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Mexico: Waiting For A Better Entry Point In Mexico, inflation has very likely peaked and will drift lower as the central bank maintains a tight monetary policy stance: A large part of the rise in inflation in 2017 was caused by depreciation in the peso. The firmness in the peso this year entails that inflation will roll over soon (Chart II-1). Consumer spending and capital expenditure are set to contract as the impact of higher interest rates continue to filter through the economy (Chart II-2). In fact, domestic vehicles sales are shrinking sharply. Chart II-1Mexico: Peso & Inflation Chart II-2Higher Interest Rates Are ##br##Slowing Domestic Spending Furthermore, weak real wage growth will continue to weigh on consumer spending (Chart II-3). In addition, contracting fiscal non-interest expenditures will remain a headwind on economic growth (Chart II-4). Chart II-3Lower Real Wages = Lower Inflation Chart II-4Belt-Tightening By The Government Finally, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of last year - will subside as the base effect of these price increases abates. The inflation rate will in turn moderate. Despite all this, Banxico will continue to keep monetary policy tight due to lingering uncertainty related to NAFTA negotiations. Within the EM currency universe, the Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. We will be looking to reinstate long positions in the MXN versus both the ZAR and the BRL for the following reasons: Relative trade balance dynamics will continue to favor Mexico relative to South Africa and Brazil. Mexican exports are likely to remain robust due to strong U.S. growth (Chart II-5), while South African and Brazilian exports will slow down as China's growth and imports falter (Chart II-6). Chart II-5Mexican Exports Will Remain ##br##Robust Due To Strong U.S. Growth Chart II-6South African & Brazilian Exports ##br##Will Take A Hit As China Slows Furthermore, metals prices will be affected more negatively than oil prices due to China's growth slump. China's share of world consumption in base and industrial metals at 50-55% is much larger than oil (12.5%). This will leave Mexican exports less negatively affected than those of Brazil and South Africa. Mexico does not suffer from rapidly rising public debt like Brazil and South Africa (Chart II-7). Large fiscal deficits and rising public debt burdens in Brazil and South Africa require a higher risk premium in their respective financial markets, leaving further room for the MXN to outperform both the BRL and the ZAR. While Mexico has already gone through some structural reforms, Brazil and South Africa have yet to deliver any substantial efforts on that front. This leaves Mexico in a much better position to attract long-term capital inflows compared to Brazil and South Africa. Finally, on a real effective exchange rate basis, the peso remains cheap relative to the rand and the real (Chart II-8). Chart II-7Public & Private Debt Is Lower In Mexico Chart II-8The Mexican Peso Is Still Cheap We closed our long MXN/BRL and long MXN/ZAR trades on October 25th because at present there is too much uncertainty with respect to NAFTA negotiations that could have a negative impact on the peso. However, with regards to the national general elections, uncertainty in South Africa and Brazil is even greater than in Mexico. In Mexico, the anti-establishment candidate Andres Manuel Lopez Obrador is currently leading the polls, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress. Investment Conclusions We recommend that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA3 negotiations before going overweight the country's currency and fixed-income markets relative to their EM peers. Mexican stocks have been selling off sharply in absolute terms and have substantially underperformed the EM benchmark. This poor performance is mainly attributed to financials and consumer discretionary stocks. While these two sectors only account for 20% of the total MSCI market cap, the retrenchment in their share price has been large enough to bring the whole market down. We have the following observations on these two equity sectors: The consumer discretionary sector has been underperforming due to disappointing earnings. Our bias is that it is still too early to call a bottom in the consumer cycle in Mexico. With regards to banks, we believe that tight monetary policy will continue to weigh on their share prices. More importantly, the yield curve remains inverted, and until we see it steepen, it will be hard for banks to rally. All in all, we continue recommending a neutral weighting in Mexican stocks within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, the link is available on page 15. 2 Banking system is the sum of the central bank and commercial banks. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights An extended period of synchronized global growth suggests above-potential U.S. growth will persist into 2018. BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. However, a new study by the SF Fed suggests that inflation could be stuck in low gear for a while longer. The U.S. consumer is poised to have a good year in 2018, aided by rising incomes, solid balance sheets and elevated confidence about future increases in employment and incomes. BCA expects a rebound in residential investment in 2018 despite higher mortgage rates. Feature BCA's Outlook for 2018 was published just recently.1 The report laid out the macroeconomic and policy themes that will impact financial markets during the next year. In this week's report we expand on those themes and discuss what they mean for the U.S. economy and financial markets specifically. A period of synchronized global growth will persist into 2018 and allow the U.S. economy to grow well above its long-term potential for a time. Overseas demand will lift U.S. profit growth in 2018, although both earnings and profit growth will peak next year. Widespread global growth and a positive output gap in the U.S. will lead to accelerating wages, higher inflation, a more aggressive Fed and higher bond yields. U.S. stocks will outperform bonds in 2018. Despite higher mortgage rates, the U.S. housing market will provide a lift to the U.S. economy in 2018 as residential investment rebounds after a challenging 2017. A peak in residential investment provides an early indication that a recession is on the horizon. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. In the long duration economic expansions in the 1980s and 1990s, residential construction provided an even earlier signal. The U.S. consumer will also add to growth in 2018, aided by solid balance sheets, near record confidence and elevated confidence about future increases in employment and incomes. Risks remain, however, and the biggest threat to our view of the U.S. economy and financial markets in 2018 is that inflation overshoots the Fed's 2.0% target. BCA's view is that inflation will return to 2% gradually. A faster pace of inflation may prompt a more aggressive Fed and catch markets off guard. If inflation fails to move back to 2%, the Fed may slow the pace of hikes, clearing the way for the current goldilocks scenario to persist even longer. Synchronized Global Growth For the first time in more than a decade, global economic activity is widespread. Led by a surge in capital spending, the economy is experiencing its strongest growth since the mid-2000s. The solid international expansion will bump U.S. industrial production and capital spending orders even higher and also support U.S. exports (Chart 1). The ebullient global backdrop may persist for a while. The OECD's global leading economic indicator is in a clear uptrend and suggests above-trend growth will persist through the end of 2018 (Chart 2). Global PMIs are also climbing (panel 2). The robust global growth has added to mounting inflationary pressures. In the U.S., the unemployment rate is below NAIRU; other OECD countries have followed suit. In all, almost 75% of member countries in the OECD are running at full employment (Chart 3). Chart 1Animal Spirits Are Stirring Chart 2Upbeat Global Growth Prospects Chart 3NAIRU Is A Global Phenomenon U.S. corporate profits will benefit from vigorous global economic activity. On average, 43% of S&P 500 sales are derived from overseas. Several sectors (Energy, Information Technology and Industrials) rely on international business for more than 50% of their sales and earnings. BCA's view that the U.S. dollar will move only modestly higher in 2018 implies that the currency will not have a major impact on EPS. When more than 90% of nations have positive GDP growth, stocks beat bonds, and the output gap narrows and closes, which leads to a lower unemployment rate and a more active Fed (Charts 4 and 5). The dollar's performance is mixed during intervals of strong global growth. The dollar climbed in the late 1990s, but sagged in the early- to mid-2000s. When global growth is strong, U.S. industrial production is generally higher. However, IP dipped in 2015 as oil prices fell at the start of the recent period of synchronized growth. Chart 4Widespread##BR##Global Growth ... Chart 5... Supports Risk Assets, Trade And##BR##A Narrower Output Gap Global growth could be derailed by any one of several threats. The risk of a prolonged flare-up in geopolitical risk in northeast Asia could curtail global trade. Furthermore, BCA's Geopolitical Strategy team expects that relations between the U.S. and North Korea will follow the example of U.S. negotiations with Iran in the mid-2000s; periodic conflicts accompanied by back channel negotiations over several years.2 A policy mistake by the Fed or China may also disrupt the global bonhomie and, in turn, slow growth. Most measures of China's credit impulse are decelerating and the Chinese government's reforms may impact growth more than we expect. Moreover, weak poll numbers may lead President Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. Bottom Line: Synchronized global growth supports BCA's view that U.S. EPS growth will top out in 2018, but will remain positive. Margins should also top out in 2018. The positive backdrop will allow stocks to beat bonds next year, and credit to outperform Treasuries, even as the Fed raises rates. The environment for risk assets will stay supportive even if inflation does not accelerate. However, our forecast could be derailed by a sudden surge in inflation in 2018. Inflation At An Inflection Point? The Fed can rest a little easier following last week's rise in their preferred gauge of inflation, the core personal consumption expenditures (PCE) price index, as the monthly rise was somewhat strong at 0.2% and the annual growth rate inched higher to 1.4% (year-over-year) in October, up from the previous month at 1.3% (year-over-year). In contrast, a diffusion index which includes the components of the PCE index, unlike the CPI, has moved back below zero, implying that inflation pressures are not yet widespread (Chart 6). Regardless of current sluggish inflation dynamics, BCA's view is that inflation will rise by enough to convince the Fed that continuing to boost rates next month is the right direction for monetary policy. However, patience will be required as it is too early to say if inflation has reached an inflection point as it is still below the Fed's 2 percent inflation target and remains persistently at a low level. Outgoing Chair Yellen's voiced this concern by saying at the September 19-20 FOMC meeting that the shortfall of inflation from 2 percent is a "mystery", which echoed Fed Chair nominee Powell's sentiment at Jackson Hole (August 2017). Furthermore, prior to the PCE release last week and in her last testimony, Yellen reiterated that "Even with a step-up in growth of economic activity and a stronger labor market, inflation has continued to run below the 2 percent rate. The recent lower readings on inflation likely reflect transitory factors. As these transitory factors fade, I anticipate that inflation will stabilize around 2 percent over the medium term. However, it is also possible that this year's low inflation could reflect something more persistent. Indeed, inflation has been below the Committee's 2 percent objective for most of the past five years." As we have discussed previously,3 though the Fed is unified on its gradual path for monetary policy, Chair Yellen's current dismay about the uncertainty for the path of inflation is not a widely held view among the members of the committee. The internal debate at the Fed about this "mystery" continues, and may heat up as four new board members join the FOMC. BCA's view is that inflation will move higher over the next year. However, a recent study4 by the FRB of San Francisco takes a different view. Economists at the San Francisco Fed concluded that the path for inflation (based on core PCE) has more downside. Their work suggests that health-care services inflation will remain a drag to core PCE due to recent changes in health care legislation. Health-care services represent about 35% of the PCE spending category identified as non-cyclical (58% of core PCE is non-cyclical or "acyclical" while 42% of core PCE is "procyclical"). Authors of the study estimated that health care services have subtracted about 0.3% from core PCE compared to the last recovery period in 2002-2007 (Chart 7). Accordingly, the unrelenting decline in health-care services inflation has prevented core PCE inflation from returning to its pre-recession average above 2 percent. Moreover, overall non-cyclical inflation is subtracting about 0.6% from core PCE inflation compared with the mid-2000s. Chart 6CPI And PCE Diffusion##BR##Indices Signals Diverge Chart 7Noncyclical Sources##BR##Driving Inflation Lower The Fed's rationale for higher rates of the previous 2004-2006 tightening cycle was quite different than today's. Just prior to the initial rate hike, the economy was "expanding at a rapid pace" and members of the FOMC had a high level of conviction that "robust growth would be sustained." More importantly, policymakers viewed the household sector as a "key driver in the expansion" as consumer spending was expected to continue to grow at a strong pace.5 Though inflation pressures were building, "most members saw low inflation (core PCE) as the most likely outcome" amid strong productivity growth. Even so, inflation persisted in an uptrend near the 2% threshold (and eventually crossed over in the following months) even as "considerable" labor market slack remained and wage growth moderated (though within the 3-4% range). That said, the bond market today is concerned about a policy mistake by the Fed. The 2/10 Treasury yield curve moved from 86 in October to 58 last week, reflecting the risk that the downward pressures on inflation remain elevated. If the i.e. transitory factors do not dissipate core inflation may get entrenched into a lower channel. The Fed may have to pause or cut short its tightening cycle if lower inflation persists and is accompanied by a decline in market-based measures of long-term inflation expectations. Bottom Line: BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. The market is only expecting one or two hikes next year. Our view is that the curve will steepen in 2018, as the market acknowledges the return of inflation. BCA's U.S. Bond Strategy service expects the 10-year Treasury yield to move above 2.8% next year, and may move as high as 3%. Stay overweight stocks versus bonds and underweight duration. U.S. Consumer Outlook Thanks to the consumer, the U.S. economy is operating very close to its long-term potential. Household balance sheets are in better shape than in the corporate sector. For example, total household liabilities are 11.3% below their long-term trend (since 1950) and have moved sharply lower since the early 1980s (17.2% in 1983Q1). Household net worth in 2017Q2 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q2 (Chart 8). House prices, based on the Case-Shiller National index, have increased steadily and have experienced their fastest yearly growth rate since June 2014 (6.15% year-over-year). Nationwide, housing prices are 46% above their 2012 trough and 6% above the pre-recession peak (July 2006). Moreover, given the equity market's recent new highs, households' financial position should continue to record further gains for at least the next two quarters (2017Q3 Flow of Funds data is due on December 7). Consumer confidence - although mostly a coincident indicator for consumer spending - continued to climb in November to a 17-year high. The increase was the result of elevated expectations for future gains in employment and income, though the latter decreased very slightly. These inflated readings may further support steady consumer expenditures at this late stage of the business cycle, especially heading into the holiday shopping season. Next week, we will examine previous spending cycles to better understand the implications for the 2017 holiday retail season. Consumers remain very optimistic about future labor market advances, making it easier ("jobs plentiful") rather than difficult to find a job ("jobs hard to get"). Furthermore, 46% of consumers expect stock market returns to strengthen in the next year in contrast to only 19% expecting stock prices to decrease over the same period. Nevertheless, there are risks that may dampen the pace of consumer spending. BCA expects employment growth to slow because the labor market cannot get much tighter. Plus, there is a shortage of skilled employees, according to the National Federation of Independent Business (NFIB) and the Fed's Beige Book. Moreover, the personal savings rate cannot sustainably remain at its recovery low of 3.2%. However, small businesses' upbeat plans for labor compensation still bode well for rising wages and salaries as they are at their highest level since March 2000. For consumer spending to flourish, overall labor income will need to improve. At 2.6%, annual wage compensation growth remains sluggish and far from the 3-4% per year that the Fed has stated would be consistent with an economy closer to a 2% inflation rate (Chart 9). Chart 8"Teflon" Household Balance Sheets Chart 9Consumer Spending Tailwinds Moreover, households are unlikely to binge on more debt to smooth out their expenditures as they did in the mid-2000s. A further acceleration in consumer spending would occur alongside steady improvement in the labor market and improving household confidence on future employment and income gains. As such, last week's income and spending report showed that while the consumer held back on real spending in October (+0.1% month-over-month), real personal income rose by 0.3% month-over-month. Real income growth troughed in December 2016 but has climbed by almost 2% in the past three months. Fed policymakers can take comfort that over the medium-term, consumer spending remains quite stable at around 2.5-3.0%. BCA still expects consumer spending to continue to grow by at least 2% pace in 2018 which should keep the expansion humming along. Bottom Line: The outlook for the U.S. consumer remains bright due to solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. This should continue to support the domestic economy and global growth, especially ahead of the holiday shopping season. Consumer headwinds to monitor are households' incentive to start saving more as wages remain stagnant and employment growth slows. However, as the fundamental tailwinds outweigh the headwinds for household spending, BCA still expects the U.S. consumer sector to remain steady over the near term. Residential Investment: More Than Just A Q4 Snapback Housing will boost GDP growth in 2018. BCA's view is that housing did not peak in early 2016 (Chart 10, panel 4). Investment in residential construction in Q2 was held down by higher rates and a mild 2016-17 winter that pulled construction ahead into Q1. Hurricanes Harvey and Irma made a major dent in Q3. A bounce in activity is underway in Q4, but we expect more than just a single quarter snapback. Instead, conditions are in place for an extended period of growth in residential investment. Low inventories, a rising homeownership rate, and a 12-year high in homebuilder sentiment, all support our bullish view (Chart 10). Inventories of unsold new and existing homes are near record lows (panel 2), and in many areas of the country, low inventories are limiting sales activity and pushing up prices. Homeownership rates are escalating again (panel 3), led by solid momentum in real disposable income, which in turn, and is a product of the booming labor market and rising wage inflation. Moreover, housing affordability will remain above average even if our forecast for a 2.8% 10-year Treasury yield is met (Chart 11). A 200 bps rise would push affordability below its long-term average for the first time in nine years. A more plausible path for rates would be a 100 bps increase in mortgage rates. Under this scenario, the affordability index would deteriorate, but remain a tailwind for the housing market. Chart 10Solid Housing##BR##Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Housing investment is not only an important gauge of economic growth, but it also is the best leading indicator among all sectors. Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP, on average seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters and an overtightening may impede the real estate market. A major change in the treatment of state and local real estate taxes and mortgage interest in the GOP tax plan may also negatively affect housing demand, particularly at the high end of the market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case Shiller home price index showed housing prices up at the fastest rate in three years. A prolonged period of home price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system that it regulates are hyper-vigilant about excesses in the housing market, and it is unlikely that another housing bubble will be tolerated.6 Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will add to growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. Moreover, a healthy housing market will continue to support solid consumer spending, the economy's largest and most important sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Outlook 2018, "Policy And The Markets: On A Collision Course", November 20, 2017. Available at bca.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Managing The Risks", published October 2, 2017. Available at usis.bcaresearch.com. 4 Mahedy, Tim and Shapiro, Adam, "What's Down With Inflation?", Federal Reserve Bank of San Francisco, November 27, 2017. http://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Minutes of The Federal Open Market Committee, May 4, 2004: https://www.federalreserve.gov/fomc/minutes/20040504.htm 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com.
Highlights Idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Idea 2: Long EUR/USD Idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Feature Question 1: Where Is The Worrying Imbalance? Last week, in the Quantum Theory Of Finance,1 we pointed out that when bond yields reach ultra-low levels, the payoff profile from bonds becomes highly asymmetric. When yields approach a lower bound, they cannot fall much further but they can rise a lot. Meaning that bond prices have very limited potential for gains, but have great potential for sudden and deep losses. Chart of the WeekThe Norway Versus Euro Area Bond Yield Spread Is Too Wide The unattractive asymmetric payoff profile - known as negative skew - applies to both nominal and real returns. This is because negative skew is concerned about deep nominal losses over a relatively short period. In which case, a deep nominal loss will be a deep real loss too.2 As equity returns always possess negative skew we can say that at ultra-low bond yields, bond risk becomes equity-like. Given this risk equalization, equities no longer justify a risk premium over bonds. And the lower prospective return required from equities means that today's equity valuations and prices become a lot richer. But the new delicate balance of valuations is conditional on bond yields remaining ultra-low. This is because the unattractive negative skew on a 10-year bond's returns disappears when its yield moves up into the 'high 2s' (Chart I-2). At this point, risk is no longer equalized and the equity risk premium must fully re-emerge - requiring today's equity market valuation and price to drop, perhaps substantially. However, the ensuing fight to havens would then once again pull bond yields back down from the 'high 2s'. It follows that the rise in expected interest rates is self-limiting. Any policy interest rate expectation already in the 'high 2s' - such as the Eurodollar December 2022 contract - cannot sustainably rise much further, whereas those that are still some way below - such as the Euribor December 2022 contract - can (Chart I-3). Which leads to our first investment idea. Chart I-2Bonds Become Much More ##br##Risky At Ultra-Low Yields Chart I-3The Euro Area/U.S. Interest Rate Expectation ##br##Spread Is Too Wide Investment idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Question 2: Which Is The Safest Currency To Hold? Chart I-4Euro/Dollar Just Tracks ##br##The Bond Yield Spread To reiterate, at ultra-low bond yields, bond returns offer a highly unattractive payoff profile. Put simply, you can quickly lose a lot more money - in both nominal and real terms - than you can make! Now observe that the payoff profile for a foreign exchange rate just tracks the bond yield spread (Chart I-4). This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive payoff profile called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, the direction of policy rate expectations cannot go significantly lower. Conversely, policy rate expectations for the Federal Reserve (for 2022) are not far from our upper bound of the 'high 2s'. So these expectations cannot go significantly higher without threatening a risk-asset selloff. On this basis, EUR/USD has more scope to gap up than to gap down. Investment idea 2: Long EUR/USD But be aware that investment ideas 1 and 2 are highly correlated with each other! Question 3: Where Are We In The Global Growth Mini-Cycle? Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May we can infer that it is likely to end in early 2018. So one surprise in 2018 could be that global growth slows in the first half rather than in the second half - contrary to what the consensus is expecting. That said, half-cycle lengths do have some degree of variation: the current upswing might be a few months longer or shorter than the average. So how can we avoid positioning too early or too late for the next turn? The answer is to focus on investments that have already fully priced the current upswing, so that timing becomes less of an issue. On this basis, we propose that the rally in industrial metals and Basic Materials equities is already extended. Our technical indicator which captures herding and groupthink correctly identified the trough at the end of 2015, the mini-peak at the end of 2016, and is now signalling that the latest rally is likely to fade (Chart I-5 and Chart I-6). Chart I-5Metals Have Fully Priced ##br##The Mini-Upswing... Chart I-6...And The Metal Rally Is Reaching##br## Its Technical Limit Investment idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Question 4: Will Inflation Lift Off? The ECB's continued indulgence with ultra-loose monetary policy would make you think that the euro area is on the edge of a deflationary abyss. In fact, inflation has been running comfortably within a 0-2% band for almost two years. Will inflation edge closer to the ECB's 2% point target? Given our view on the growth mini-cycle, not immediately. In the first half of 2018, inflation may even edge lower within the 0-2% band, but this global dynamic will affect inflation in all jurisdictions, not just in the euro area. There is nothing wrong with inflation running comfortably within a 0-2% band. Now that we know that nominal interest rates can go slightly negative, a 0-2% inflation band even permits negative real interest rates. The big mistake is to aim for an arbitrary point target, like 2%. This is because inflation is a non-linear phenomenon, and a defining characteristic of a non-linear phenomenon is that it cannot hit an arbitrary point target.3 It is our high conviction expectation that the major central banks will eventually change their point targets for inflation into target bands such as 0-2% or 1-3%. But afraid to lose credibility, they will not change tack abruptly. In the meantime, we notice that the Norges Bank is undershooting its 2.5% inflation target by considerably more than the ECB is undershooting its 2% target (Chart I-7). Yet the yield spread between Norwegian and euro area bonds has not caught up with this reality (Chart of the Week). Chart I-7The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB Investment idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Question 5: Will Political Risk Re-emerge? Political events have had a hand in three of the sharpest recent moves in financial markets. The vote for Brexit catalysed a 15% decline in the pound; the vote for Trump triggered an 80 bps spike in the 10-year T-bond yield, and the vote for Macron unleashed a 10% rally in the euro. Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism (perhaps unrealistically); and the election of Macron exorcised the potential chaos of a Le Pen presidency. Chart I-8The U.K. Versus Ireland Bond ##br##Yield Spread Is Too Wide In contrast, the recent (disputed) vote for independence in Catalonia, and the breakdown of coalition discussions in Germany barely moved the markets - because neither event changed expectations of long-term economic outcomes. As investors, this is the test we should apply to all political events. In 2018, the evolution of Brexit has the potential to move markets. This is because hard Brexiters and the EU27 are on a collision course. Specifically, the issue of the Irish border is insoluble. It is Brexit's Gordian knot. Theresa May has promised the hard Brexiters that the U.K. will leave the EU customs union and single market. She has also promised the Northern Ireland Unionists - who are propping up May's minority government - that there will be no hard border between Northern Ireland and the Republic of Ireland or the rest of the U.K. But these promises are irreconcilable. The Republic of Ireland will veto a border that threatens the Good Friday peace agreement; the Northern Ireland Unionists will not tolerate the border moving to the Irish Sea, which would effectively take Northern Ireland into the EU customs union and single market; and the EU27 will block a Hong Kong type 'free port' status for Northern Ireland - as this would remove the integrity of harmonized standards across the EU. Eventually, the impenetrable Irish border problem is likely to be the roadblock to a hard Brexit. But first there needs to be a collision. And the collision could move markets. With the yield spread between U.K. 10-year gilts and Irish 10-year bonds near a 2-year wide (Chart I-8), this leads us to our fifth investment idea. Investment idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Quantum Theory Of Finance' November 23 2017 available at eis.bcaresearch.com. 2 For example if the nominal return over 3 months was a very painful -10%, and inflation was running at -10% per annum, the real return over 3 months would be a still very painful -7.5%. 3 Please see the European Investment Strategy Weekly Report 'Three Mantras For Investors' August 17 2017 available at eis.bcaresearch.com. Fractal Trading Model* Ahead of the OPEC meeting on November 30, the WTI crude oil price is vulnerable to any disappointment - because its rally is technically very extended. This week's trade recommendation is to expect a retracement of 7.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. 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 Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.
Highlights The so-called 'Silver Tsunami' of retiring baby boomers will continue to be a drag on aggregate wage growth for some time. We would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. Overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The global inflation mini-cycle will turn down in early 2018. Approaching the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Feature Last week, the Bank of England pointed out that "some of the softness in recent pay outturns had related to the composition of employment, with the number of low-paid jobs growing disproportionately."1 Separately, a recent study by the Federal Reserve Bank of San Francisco described the exact same phenomenon in the United States. "The drag on wage growth reflects changes in workforce composition."2 The San Francisco Fed study highlighted two paradoxes. The first paradox is that for continuously full-time employed workers, wages are actually rising quite strongly. For the continuously employed, pay is growing close to the rate seen at the previous economic peak in 2007 (Chart I-2). Chart of the WeekThe Inflation Mini-Cycle Will Turn Down In Early 2018 Chart I-2Will The Real Wage Inflation Please Stand Up However, the entry of new and returning workers to full-time employment continues to depress aggregate wage growth - because new entrants generally earn less than workers who are leaving full-time employment. This creates the second paradox. Strong job growth can actually pull down average wages in the economy and slow the pace of aggregate wage growth. Solving The Wage Puzzle According to the San Francisco Fed, this 'composition effect' is exceptionally pronounced right now because of the large-scale exit of higher-paid baby boomers from the labour force. This has depressed aggregate wage growth by 2 percentage points, a sizeable effect relative to the normal expected wage gains. Furthermore, with so many of the baby boomer generation still approaching retirement, "the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time." A second very important factor is at play. The current wave of technological progress is having its most disruptive impact on middle-income jobs. As we explained in Why Robots Will Kill Middle Incomes,3 "high-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources." The upshot is that when baby boomers retire, automation and Artificial Intelligence (AI) are replacing many of the jobs that the boomers occupied in high-income and middle-income sectors such as Finance and Manufacturing, rather than opening up these formerly lucrative career paths to new entrants. Therefore, new entrants are flooding into industry sectors which AI cannot yet disrupt but which are traditionally much lower paid with limited prospects for advancement - sectors like Food Services and Drinking Places and Administrative and Support Services (Table I-1). Table I-1Which Sectors Are Creating The Most Jobs? In summary, for the continuously employed, wages are rising healthily. But for aggregate wage growth, the composition effect from retirements and new entrants is an exceptionally strong headwind. What does this mean for overall inflation? The study concludes that as long as the economy can keep its wage bill low by replacing retiring staff with AI and with lower-paid workers, "labour cost pressures for higher price inflation could remain muted for some time." Given that the next wave of AI is just about to hit us, we expect these conditions to hold true in all developed economies for at least the next five years. Solving The U.K. Productivity Puzzle Chart I-3Since The Global Financial Crisis U.K. ##br##Productivity Has Stagnated But the San Francisco Fed study does also carry a warning about a latent inflationary threat. If productivity growth is slowing, "continued increases in unit labour costs could be hiding behind low readings on measures of aggregate wage growth." This seems to be a particular worry in the U.K. Since the global financial crisis, serial disappointments in productivity growth have concerned the Bank of England (Chart I-3). However, the Bank need not worry. We would like to present a very simple explanation for the U.K.'s so-called 'productivity puzzle'. Big clues come from comparing and contrasting the economic recoveries of 1993-2000 with 2009-17. At the very beginning of the two recoveries, productivity growth evolved in the same way. But then it took drastically different paths. Through the late 1990s, productivity growth accelerated, whereas through the 2010s productivity has stagnated. Why? A plausible explanation comes from the mirror-image patterns in self-employment. At the very beginning of the two recoveries, self-employment evolved in the same way. But through the late 1990s self-employment fell by 300,000, whereas through the 2010s self-employment has increased by a million, accounting for 30% of all jobs created (Chart I-4, Chart I-5, Chart I-6, Chart I-7). Furthermore, there is a tell-tale pattern. Whenever self-employment has picked up most sharply - for example, 2011-13 and 2015 - productivity growth has taken a big hit. Chart I-41990s Recovery: ##br##Self-Employment Fell Chart I-52010s Recovery: Self-Employment ##br##Has Risen Sharply Chart I-6Compare And Contrast: ##br##The Pattern of Self-Employment... Chart I-7...And Productivity...##br##Are Mirror-Images What's going on? Contrary to popular belief, the self-employed are not innovative entrepreneurs, who might typically boost productivity. The Office for National Statistics itself has poured cold water on the increased innovation thesis, claiming that "while there has been an increase in the number of people who are self-employed there has been a reduction in the number of employees who work for the self-employed." Given that these new self-employed work for themselves with no employees of their own, the idea that they are innovative entrepreneurs is a long way from the truth. In reality, the new model army of self-employed consists of former employees in sectors like journalism, media and technology who are now freelancing. And this provides a simple explanation for the productivity puzzle. Job creation that is skewed to self-employment depresses productivity growth. The reason is that the army of self-employed have to carry out tasks in which they have no specialism, and in which they are therefore much less productive. For example, a freelance journalist must spend time managing her IT gremlins, accounts, sales pitches, and so on, rather than focussing entirely on her special skill of writing powerful news stories. This makes her much less productive as a freelancer than as an employee. However, this hit to productivity eventually abates in one of two ways: freelancers gradually become more adept at the new tasks they must undertake; or more likely, they switch back to employee jobs in which they are much more productive. Combining the messages from the first two sections, the Bank of England need not fear labour cost pressures for higher price inflation. Furthermore, with Brexit negotiations progressing at a snail's pace, U.K. based companies are getting increasingly nervous about what their future international trading relationships will look like. So we would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. The investment conclusion is to overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The Inflation Mini-Cycle Will Turn Down In Early 2018 Last week, we reviewed our mini-cycle framework for the global economy. To recap, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern with each half-cycle lasting about 8 months. As the current mini-upswing started in May, we are likely more than half way through the mini-upswing - with an expected end around January/February 2018. At which point, the cycle will enter a mini-downswing. The mini-cycle framework is so powerful that it also perfectly explains the mini-cycles in commodity price inflation - specifically, metals - and unsurprisingly, in overall inflation too. To anybody who still doubts the existence of these remarkably regular mini-cycles, the Chart of the Week and Chart I-8 should put the doubts to rest once and for all. Chart I-8Metal Price Inflation Also Exhibits Remarkably Regular Mini-Cycles Make no mistake. The mini-cycle in commodity prices and overall inflation will turn down in early 2018. So as we approach the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From the Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on November 1, 2017. 2 From the SF Fed blog 'The Good News on Wage Growth' August 14. 2017. 3 Please see the European Investment Strategy Special Report 'Why Robots Will Kill Middle Incomes' August 10, 2017 available at eis.bcaresearch.com. Fractal Trading Model* The near 20% rally in Japan's Nikkei 225 since early September has taken its 65-day fractal dimension to its lower bound, suggesting a likelihood of a trend-change. So our recommended trade this week is short Nikkei 225 / long Eurostoxx50 with a profit target / stop loss set at 3%. We now have six open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Chart II-6Indicators To Watch -##br## Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch - ##br##Interest Rate Expectations