Monetary
NOTE: There will be a few minor scheduling changes to BCA's China Investment Strategy service in July. We will publishing next week's report and the report scheduled on July 25 one day late, on Thursday, July 5 and 26, respectively. There will also be no report on Wednesday, July 18 due to our regular summer break. Highlights In response to the sharp spike in the risk of a full-blown U.S./China trade war, many market participants have concluded that significant fiscal and/or monetary policy stimulus is forthcoming. But for now, a depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it also increases the risk that the U.S. will follow through with the worst of their threats. Despite two conceivable upside scenarios for the equity market, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan trade for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Feature Chart 1A Decisive Technical Breakdown In ##br##Ex-Tech Stocks Vs Global In a Special Alert last week, we recommended that investors downgrade Chinese ex-tech stocks versus their global peers to neutral from overweight,1 after having placed them on downgrade watch at the end of March.2 Our recommendation was made in response to the ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices.3 It was also timely, as Chinese ex-tech stock prices have now decisively broken below their 200-day moving average (Chart 1). Following our shift in stance, the question facing BCA's China team, as well as global investors, is straightforward: Now what? Stimulus Watch The answer to this question among many market participants is that fiscal and/or monetary policy stimulus is forthcoming. We have no doubt that China will announce some remedial or compensatory measures in response to protectionist action from the U.S. Indeed, recent statements from the Ministry of Finance (MOF) suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. However, we have argued that the bar for a fresh round of material stimulus is higher today than it was in the past, and we continue to hold this view. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy likely needs to feel more pain before policymakers come to its aid with enough magnitude to potentially spark another upswing in economic activity. Below we outline a few perspectives on the potential for stimulus, and how investors can gauge whether policymakers are deploying enough stimulus to materially impact China's economic outlook: Fiscal Stimulus The MOF's statement reflects the first fiscal policy action that China would likely take to combat any economic weakness, which is to speed up spending that has already been approved but was planned to occur later in the year. But from the perspective of whether a policy action is likely to materially boost economic activity, frontloading pre-approved spending would qualify, at best, as a remedial measure. In our view, tracking China's budgetary government finance data represents the best method for investors to determine whether policymakers are truly stimulating via the fiscal channel. While it is true that China's shadow budget deficit is much larger than the official data show (Chart 2), there is a crucial aspect of China's recent mini-cycle that is not well understood by many investors: almost all of the expansion of China's fiscal stance from 2014-16 was from on-budget rather than off-budget spending. Given that China has been trying to limit off-budget spending as part of its structural reform program, our sense is that this time won't be different if China decides that significant fiscal stimulus is required. This is good news for investors, given that on-budget spending is easier to observe in real-time, and Chart 3 presents two simple measures that we are using to monitor China's fiscal stance, alongside their year-over-year changes: on-budget expenditure and the on-budget balance, both as a % of GDP. Based on these measures there are no signs yet that the fiscal stance is easing (in fact, the opposite has occurred over the past year), but we will watching Chart 3 closely over the coming months for any indication of a change. Chart 2China's Shadow Budget Deficit Is Large... Chart 3...But If China Stimulates It Will Likely Be On-Budget Monetary Stimulus In our judgement, the recent cut to the reserve requirement ratio is not likely to be effective at stimulating the domestic economy. Investors should note that the initial reaction of many market participants to the April 17 reserve requirement ratio cut of 1% was that it represented a shift in the PBOC's policy stance towards easing, which ultimately proved to be a false narrative. Chart 4 shows China's 3-month interbank repo rate (China's de-facto policy rate which leads average lending rates), and highlights the timing of two specific events: March 28, when news broke that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, and April 17, when the PBOC announced its targeted reserve requirement ratio cut. The chart makes it clear that the decline in the repo rate was in response to the deadline extension rather than the repo rate cut. This is entirely consistent with the findings of our February 22 Special Report,4 particularly the fact that 75% of the monetary tightening that has occurred since late-2016 has been regulatory in nature. We have previously argued that the dip in the repo rate in response to the deadline extension would probably be temporary,5 and Chart 4 shows that the rate has indeed increased over that past two months. In short, there is no evidence that the April 17 reserve ratio cut had any measurable effect on the stance of monetary policy in China. Given this, there are two key points for investors. The first is that small cuts to the reserve requirement ratio should be viewed, at best, as remedial measures that may help blunt the impact of shock to the export sector, but they are unlikely to alter the downward trajectory of the "old economy" (the portion of China's economy that is most relevant to global investors). The second is that if cuts to the reserve requirement ratio or any other monetary policy action stimulates the provision of credit via easier lending standards (rather than by reducing the cost of borrowing), their effect should result in a pickup in broad measures of credit growth rather than a reduction in interest rates. Chart 5 highlights that, for now, no such pickup has occurred; adjusted total social financing, which excludes equity issuance but includes municipal bonds, remains in a downtrend. This series, along with its impulse equivalent, are both included in the BCA Li Keqiang Leading Indicator which is at the core of our efforts to monitor the cyclical condition of China's business cycle. Chart 4No Evidence That April RRR Cut Eased Interest Rates Chart 5No Evidence That April RRR Cut Eased Lending Standards The Exchange Rate BCA's Geopolitical Strategy team has recently argued that China is likely to retaliate to a potential tariff imposition by weakening CNY/USD. This would have the effect of improving the competitiveness of exports priced in RMB, or would bolster the revenue of exporters selling goods priced in U.S. dollars (by way of receiving more RMB after converting the dollars received). Evidence has emerged over the past week to suggest that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar. Chart 6 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have, until very recently, reflected the strength in the U.S. dollar. However, the chart shows that CNY/USD has fallen over the past few days by magnitude in excess of what would be expected given movements in the U.S. dollar, implying that the very recent weakness is likely policy-driven. Chart 6The PBOC Is Letting CNY/USD Depreciate We agree that depreciating the currency versus the U.S. dollar will improve the financial condition of domestic exporters, but we would also caution investors against looking at a deep depreciation in CNY/USD in an encouraging light. We have noted in previous reports that such a development would be a clear sign of an outright, full-scale trade war between the U.S. and China, and in this context currency deprecation should still be classified as just a remedial measure (i.e. it is unlikely to lead to a renewed upswing in Chinese economic activity). Bottom Line: A depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it may also invite even further protectionist action from the U.S. Investment Recommendations Our recommendation to cut Chinese ex-tech stocks to neutral means that investors should be looking both for upside and downside risks when judging when to make their next allocation shift. For now, our discussion above underscores that we view the risks largely to the downside. The scenario that would cause us to further downgrade Chinese stocks to underweight within a global equity portfolio is not difficult to imagine: the worst outcome in the U.S. / China trade dispute materializes, the global economy slows meaningfully, and the inertia from the ongoing structural reform program causes Chinese policymakers to limit their stimulus to compensatory, remedial measures until a painful slowdown emerges in the domestic economy. We are not yet past the "point of no return" on the way to this outcome, but the events of the past two weeks have clearly moved us further along the path. Conversely, there are two scenarios that we can envision that could cause us to upgrade Chinese stocks back to overweight: Chart 7Keep Monitoring Floor Space Sold A protectionist exchange occurs between China and the U.S. but fails to devolve to the most damaging outcome. China's remedial measures are successful at easing the pain from tariffs on domestic producers, and the economic outlook stabilizes. In this scenario the most acute risk would be removed, but the gradual underlying downtrend in China's "old economy" would be intact. In this case we would be more comfortable upgrading Chinese stocks if there was an additional reflationary tailwind, such as a boost from fiscal spending or some reversal of the monetary tightening that has occurred since late-2016. But a significant, exogenous acceleration in economic activity from some other sector of China's economy would also fit the bill, and we have argued in past reports that housing appears to be the best candidate. Chart 7 highlights that residential sales volume may now be in a gradual uptrend, which could translate into stronger construction in the months ahead. The second scenario that would cause us to upgrade Chinese stocks is straightforward: Chinese policymakers determine that the risks to growth from an export shock are unacceptably large given the existing slowdown in the industrial sector, and decide to temporarily reverse course on the structural reform path by opting for "big bang" fiscal and/or monetary stimulus. A significant and highly investment-relevant mini-cycle upswing occurred in China the last time that the authorities strongly prioritized growth, and we will watching closely for real indications of a shift in attitude in this direction. For now our judgement is that policymakers have a higher pain threshold than in the past, suggesting that this is outcome is not yet probable. Related to our decision to downgrade Chinese ex-tech stocks to neutral within a global equity portfolio, we have three updates to our trade book: We are closing our long MSCI China / short MSCI Taiwan position and upgrading our Taiwanese cyclical stance to neutral: Despite being massively overweight technology stocks, Chart 8 highlights that Taiwan is a comparatively low-beta equity market versus China. Our trade has generated a 21% return since we initiated it in February 2017, and we believe it is time to book profits. Given Taiwan's small size it is actually possible that its economy and/or equity market will suffer disproportionately if the worst U.S. / China trade outcome materializes, which could cause us to revisit the trade. But for now our judgement is that a neutral position is warranted. We are sticking with our long China onshore corporate bond trade: We would certainly expect credit spreads on Chinese corporate bonds to flare in response to a deteriorating economic outlook, but we highlighted in our June 13 Weekly Report how high the bar is for investors to lose money on these bonds.6 In short, China's corporate bond market already offers a margin of safety given its high yield and a comparatively short duration, and we do not see recent developments on the trade front as a sufficiently compelling reason to exit the trade. We are initiating a new trade - within the MSCI China index, long low-beta sectors / short benchmark: Chart 9 presents the relative US$ stock price return of a portfolio of low-beta level 1 GICS sectors within the MSCI China index, relative to the index itself. Our methodology in calculating the portfolio is the same as that employed in the A-share factor analysis that we presented in our June 13 report; namely it is a value-weighted portfolio of sectors with below-median rolling 1-year market beta.7 The chart shows that the portfolio has outperformed over time, but sold off quite substantially last year as the high-flying tech sector boosted the performance of the overall index. The relative performance trend for low-beta has recently strengthened and crossed above its 200-day moving average, which we regard as a supportive technical signal to initiate the trade. Chart 8Taiwan's Equity Market Is Low Beta Vs China's Chart 9Go Long Low-Beta Sectors Vs The Broad Market Bottom Line: Despite two potential upside scenarios, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com. 3 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 6 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. 7 The current sector weights of the portfolio are: 26% telecom services, 24% industrials, 19% health care, 16% utilities, and 14% consumer staples. Cyclical Investment Stance Equity Sector Recommendations
Highlights Fed: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. ECB: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Feature Chart Of the WeekFed Vs. ECB: Still Diverging Central bank watching used to be a fairly black and white endeavor for investors and analysts. Policies were either "hawkish", "dovish" or perhaps "neutral". New buzzwords have entered the lexicon in the post-crisis era, however, as central banks have often struggled to adjust policy settings without upsetting financial markets. Now, the combination of action on interest rates and central bank communications can create additional types of policy moves, like a "hawkish hold" or a "dovish hike". With the Federal Reserve and the European Central Bank (ECB) announcing policy moves last week, we dedicate this Weekly Report to our assessment of the actions taken by each bank, while trying to throw a few more monetary policy buzzwords into the mix to describe their decisions. Our conclusion is that while there is a need to see tighter monetary conditions on both sides of the Atlantic, the Fed is still delivering a combination of rate changes and language that is creating more upside for bond yields in the U.S. than in Europe (Chart of the Week). The Fed: Hawkishly Hawkish The Fed sounded a confident tone at last week's policy meeting, delivering another 25bp rate hike while also upgrading its growth and inflation forecasts for 2018. In the press conference following the FOMC meeting, Fed Chairman Jerome Powell expressed a very upbeat view on the state of the economy and even sounded a bit surprised as to how resilient growth has been. Yet it appears that the Fed is still erring a bit on the cautious side when it comes to its economic growth projections and, by association, its inflation forecast. The Fed now expects U.S. real GDP growth of 2.8% in 2018, up a mere 0.1 percentage point from its projection from last March. Yet the economy has accelerated in the recent months and the Atlanta Fed's GDPNow model is calling for growth to hit a whopping 4.8% in the second quarter. While that model tends to over-predict actual growth outcomes, it does underscore how strong the current run of U.S. data has been and how the risks on the economy are tilted to the upside. That strength is also manifesting itself in robust business confidence, as evidenced by the latest read on small business optimism from the National Federation of Independent Business (NFIB) that was released last week.1 The overall NFIB Optimism Index reached the second highest level in its 45-year history in May, while a record number of respondents felt that now was a "good time to expand" (Chart 2). Reports of positive earnings trends also hit a record high, while reports of positive sales growth were the highest since 1995. At the same time, concerns about labor quality hit the second highest level in the history of the NFIB survey, while reports of compensation increases hit a record high. This booming economy is also impacting price-setting behavior, with reports of actual and planned price increases hitting the highest levels in a decade. Against this backdrop of very robust growth, the Fed did lower its forecast for the unemployment rate for 2018 (now 3.6%), 2019 (3.5%) and 2020 (3.5%). Yet its 2018 projections for headline and core PCE inflation were only nudged up by 0.2 percentage points (to 2.1%) and 0.1 percentage points (to 2.0%), respectively. Inflation is expected to remain around those levels in 2019 and 2020. Does the Fed still believe that NAIRU in the U.S. is 4.5%? If so, there is a serious disconnect between its unemployment and inflation forecasts - one that is more likely to be resolved via higher inflation, especially if those readings from the NFIB data are to be taken at face value. The FOMC did send a mildly hawkish message last week through its interest rate projections (the "dots"). They added one more expected rate increase to 2018, which would bring the total amount of hikes this year to 100bps. However, no cumulative additional increases were added beyond 2018, which means that the Fed merely pulled forward a rate hike that would have occurred in 2020. We still anticipate that a 25bps-per-quarter pace of hikes is the most likely outcome for the Fed over the next year, especially now that the inflation-adjusted funds rate is hovering around the Fed's own estimate of the neutral "r-star" level. That path of rates is still not fully discounted in U.S. money markets (Chart 3), however, which suggests that Treasury yields will remain under upward pressure from a higher front-end of the yield curve. Chart 2U.S. Economy Is On Fire Chart 3Market Still Not Fully Converged To Fed Dots The Fed will likely err on the side of caution regarding the pace of rate increases, however, given the fact that a) wage growth is still relatively subdued given how tight the labor market is; b) TIPS breakevens are not yet at levels consistent the with the market believing that the Fed has achieved its inflation target; c) the rising U.S. dollar is tightening monetary conditions at the margin; and d) the growing threat of a U.S.-vs-The-World trade war may pose a more serious risk to global growth. Yet all those factors are likely not enough to derail the booming U.S. growth locomotive. Only a move to an outright restrictive Fed monetary policy will make that happen. However, at the moment, the Fed seems more willing to tolerate a potential overshoot of its inflation target than to try and slow an overheating economy. This means that Treasury yields will likely rise through higher inflation expectations, as well as through a convergence of market pricing to the Fed's interest rate projections. Stay below-benchmark on U.S. Treasury market duration exposure. Bottom Line: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. The ECB: Dovishly Hawkish The ECB announced last week what had widely been expected by the market - that there would be no net new bond buying in its Asset Purchase Program (APP) after December of this year. Yet at the same time, the central bank was able to convey a dovish signal on the timing and pace of rate hikes after the bond purchases stop. Financial markets latched onto the latter message, triggering a rally in euro area bond markets and a daily decline of two big figures on EUR/USD. The central bank sounded a very confident tone - perhaps, surprisingly so - on both the growth and inflation outlook. ECB President Mario Draghi described the deceleration of the euro area economy in the first quarter as a "soft patch" and that the 0.4% (non-annualized) growth in real GDP was "still high growth". Draghi went even further in his description of the strong economy seen last year, and the slowing seen so far in 2018, as being largely driven by external demand: "Basically, it's a pullback from the very high levels of growth in 2017, mostly justified by an extraordinary pickup in exports, which is unlikely to repeat itself now, compounded by an increase - an undeniable increase in uncertainty - and for a variety of reasons really, mostly geopolitical reasons, and some temporary and supply-side factors at both the domestic and the global level as well as weaker impetus from external trade." That assessment for the cause of the Q1/2018 growth slowdown is accurate, as the peak in euro area data such as the manufacturing PMI, industrial confidence and the OECD's leading economic indicator all occurred alongside a slowing of export growth (Chart 4). Yet the ECB may be too optimistic in thinking that the softening in export demand will prove to be "temporary". In the ECB's updated macroeconomic projections, the forecast for real GDP growth in 2018 was revised down from 2.4% to 2.1%, largely due to a reduction in expected export growth from 5.3% to 4.2%. Yet the GDP forecasts for 2019 (+1.9%) and 2020 (+1.7%) were unchanged, and the export growth projection for 2019 was upgraded from 4.1% to 4.4%. That is a view that may prove to be too optimistic. Global trade activity is slowing fast at the moment, primarily on the back of diminished Chinese demand (bottom panel), and leading economic indicators (outside of the U.S.) have rolled over. With U.S. President Donald Trump now turning his protectionist trade rhetoric into actual tariff actions - aimed not just at China but also Europe - the risks are all to the downside for the ECB's growth projections. We find it a bit surprising that the market reacted so strongly to the ECB's indication that interest rates would be kept at current levels "at least through the summer of 2019".2 That language is consistent with the message that the ECB had been signaling prior to last week that any rate hikes would not take place soon after the net new bond purchases end. Taking the ECB's statement at face value, it would suggest that September 2019 is the first possible "live" meeting where a rate hike could occur. According to a survey of economists taken in early June by Bloomberg, the consensus view was that the net bond purchases would stop in December, the ECB would raise the deposit rate in the second quarter of 2019, and then raise the main refinancing rate (the ECB's primary policy rate) from 0% in the third quarter of 2019.3 This is broadly consistent with the pricing we see in our own "months-to-hike" indicator for the euro area, which shows that a 10bp rate increase is priced into the euro Overnight Index Swap (OIS) curve by August 2019, but with a full 25bps of increases not discounted until March 2020 (Chart 5). That date for the 10bp hike was at June 2019 on the day prior to last week's policy meeting, so the market repriced more or less in line with the ECB's messaging on the potential timing of that first hike. Chart 4Is The ECB Too Optimistic On Growth? Chart 5Market & ECB Are In Agreement Draghi gave no specific indication as to which of the ECB's policy rates would be moved first - when the ECB finally does decide to move - nor what the size of that first move could be. Yet even if the ECB "goes small" on that first move and does not move in 25bp increments like the Fed has been doing, that outcome has now been largely been discounted in the money market yield curve. Our view remains that there will be no rate hikes from the ECB until euro area core inflation and, more importantly, inflation expectations are much higher (Chart 6). As a rough rule of thumb, the ECB's previous rate hikes during the mid-2000s tightening cycle, and even the much-criticized hikes in 2011 that played a role in triggering the European Debt Crisis, did not occur until market-based inflation expectations measures like the 5-year CPI swap, 5-years forward were above 2% (bottom panel). Realized core euro area inflation was pushing toward 1.5-2% during those prior two episodes, which the ECB is not projecting to occur until later in 2019. So with core inflation only at 1.1%, and with inflation expectations still mired at 1.7%, the market is correct to take the ECB at its word that it will not even consider raising rates until next September. So why did bond yields and the euro decline after last week's ECB meeting? Perhaps it was Draghi mentioning in his press conference that bond purchases could be restarted, if needed: "[...] APP is not disappearing; it remains part of the toolbox. It's a new instrument of monetary policy that will be used for contingencies that we don't see now, and that's what we anticipate. But it remains now as a normal instrument to monetary policy." This is not a provocative statement, of course. The Bank of England did exactly that - restarting its quantitative easing (QE) program after the shock of the 2016 Brexit vote - while the Fed has also stated that it could do more rounds of QE in the future if the situation required it (but only after the funds rate had been cut back to the zero once again). Perhaps by leaving the door open a crack to ramping up the APP again, at a time when euro area growth is decelerating and core inflation remains well below target, the ECB was seen by the market to be hedging its bets with regards to exiting the current extraordinarily accommodative monetary policy settings. The ECB has been trying to communicate consistently over the past few months that the decisions on stopping bond purchases and hiking interest rates should be treated separately. In other words, a decision on the former would not have any sort of immediate implications for the latter. We discussed the possibility of the ECB avoiding a Fed-style Taper Tantrum when it exited its APP program back in March.4 Our conclusion was that while the ECB had been absorbing a greater share of government bond issuance than the Fed ever did during its QE programs, the "flow effect" of the ECB buying fewer bonds as it exited the APP would still push up euro area bond yields through the normalization of negative term premia (Chart 7). The ECB has been arguing that the "stock effect" of it owning such a large share of the euro area bond market has created a scarcity of risk-free assets that will keep yields subdued. Yet as was shown in the U.S. experience, the bigger impact on U.S. Treasury yields from its QE program was the signaling effect on the expected path of interest rates post QE. That can be seen by the very tight correlation between the term premium on 10-year U.S. Treasury yields and our measure of the market's expectation for the neutral rate fed funds rate - the 5-year U.S. OIS rate, 5-years forward minus the 5-year U.S. CPI swap rate, 5-years forward (Chart 8). A similarly tight correlation exists in the euro area interest rate markets (bottom panel), suggesting that the ECB may have a tougher time keeping a lid on bond yields than they expect if the market starts to raise the expected path of interest rates at a faster pace than the ECB would like to see. Chart 6ECB Will Not Hike Until Inflation ##br##Expectations Are Much Higher Chart 7The 'Flow Effect' Of Less ECB Buying##br## Will Boost Bond Yields Chart 8Markets Do Not Treat Tapering ##br##& Rate Hikes Separately For now, the uncertainty of the current state of euro area economic growth, combined with core inflation that is still undershooting the ECB's target, suggests that euro area bond yields will remain subdued in the near term. Yet as the ECB begins to cut its pace of asset purchases after September of this year, a slow drift higher in euro area bond yields is still the most likely outcome. If the euro area economy rebounds as the ECB expects, then the risk of an even bigger move higher in yields would increase as the market reprices the ECB rate hike cycle, although only if accompanied by an acceleration in core inflation and inflation expectations. We are maintaining our strategic recommendation to stay below-benchmark on duration risk within euro area bond portfolios. In terms of country allocation, we are sticking with our modest underweight stance, however, although we do still prefer owning core European bonds over U.S. Treasuries (especially on a currency hedged basis into U.S. dollars), as the risks of higher bond yields are still much greater in the U.S. than in Europe. Bottom Line: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.nfib.com/surveys/small-business-economic-trends/ 2 http://www.ecb.europa.eu/press/pressconf/2018/html/ecb.is180614.en.html 3 https://www.bloomberg.com/news/articles/2018-06-07/draghi-s-bond-buying-era-seen-ending-as-ecb-gears-up-for-talks 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Monetary Policy: Position for rate hikes of 25 bps per quarter for the next 6-12 months and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Yield Curve: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. IG Credit: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Feature "You just let the machines get on with the adding up," warned Majikthise, "and we'll take care of the eternal verities, thank you very much. [...] "That's right," shouted Vroomfondel, "we demand rigidly defined areas of doubt and uncertainty!" - The Hitchhiker's Guide To The Galaxy, By Douglas Adams Jerome Powell put his stamp on Fed communications at last week's FOMC meeting. He trimmed 100 words from the policy statement and began his post-meeting press conference with a concise "plain-English" summary of how the economy is doing. In short: "the economy is doing very well". But while he expressed confidence in the Fed's assessment of the economy, he was also keen to point out areas where the outlook is cloudier. His central theme seemed to be that we must delineate between those questions that can be addressed by the Fed's reading of the economic data and those that are better left to the philosophers in Douglas Adams' novel. The Chairman stressed the uncertainty surrounding two concepts in particular: the non-accelerating inflation rate of unemployment (NAIRU) and the neutral (or equilibrium) interest rate, even advising that "we can't be too attached to these unobservable variables." But what can we say about these traditionally important policy guideposts? And more importantly, how should we think about them when formulating an investment strategy? The Importance Of NAIRU Chart 1The Fed's Projections One issue that came up repeatedly in the Chairman's press conference was the seeming disconnect between the Fed's labor market projections and its inflation projections. The Fed expects the unemployment rate to fall far below NAIRU during the next two years, and yet it anticipates only a mild overshoot of its inflation target (Chart 1).1 Ultimately this disconnect will be resolved in one of two ways. Either the Fed is underestimating the inflation pressures that will result from running the unemployment rate so far below NAIRU and will be forced to hike rates more quickly than anticipated, or it will eventually revise its estimate of NAIRU downward. From an investment perspective, this disconnect will only matter if inflation starts to rise more quickly than anticipated and the Fed is forced to ramp up the pace of rate hikes. We discussed this possibility in a recent report and concluded that, on a 6-12 month horizon, the odds of the Fed hiking more quickly than its current 25 bps per quarter pace are low.2 This is principally because the Fed will likely tolerate a fairly substantial overshoot of its inflation target before it feels the need to tighten more quickly. The Importance Of The Neutral Rate For bond investors the theoretical concept of the neutral (or equilibrium) interest rate is much more important. This interest rate represents the threshold between accommodative and restrictive monetary policy. When the fed funds rate is above neutral we should expect the pace of economic growth to slow and inflation pressures to dissipate. At present, the majority of FOMC participants estimate that the neutral fed funds rate is between 2.75% and 3%. At the Fed's current 25 bps per quarter pace, the funds rate will reach neutral by the middle of next year (Chart 2). Chart 2The Federal Funds Rate Will Hit Neutral Next Year The important question for investors is whether the Fed will start to slow its rate hike pace at that time, or whether it will revise its estimate of the neutral rate based on trends in the economy. Chairman Powell's emphasis on uncertainty makes us lean toward the latter. In a recent report we outlined three factors to monitor that will help us determine whether monetary policy is accommodative (fed funds rate below neutral) or restrictive (fed funds rate above neutral).3 The first factor is the year-over-year growth rate in nominal GDP relative to the fed funds rate (Chart 3). Historically, the year-over-year growth rate in nominal GDP falling below the fed funds rate is a reliable (though often lagging) signal that monetary policy has turned restrictive. A more leading signal of restrictive monetary policy is the proportion of nominal GDP that comes from the most cyclical (or interest rate sensitive) sectors of the economy. Those sectors being consumer spending on durable goods, residential investment and investment on equipment & software. When cyclical spending declines as a proportion of overall growth it is often a sign that the fed funds rate is above its neutral level (Chart 3, panel 2). Finally, we also recommend monitoring the price of gold for clues about the neutral rate of interest. Gold tends to appreciate when the stance of monetary policy becomes more accommodative and depreciate when it becomes more restrictive. The steep decline in the gold price between 2013 and 2016 even preceded downward revisions to the Fed's estimate of the neutral rate (Chart 4). Going forward, an upside breakout in the price of gold would be a signal that we should revise our estimate of the neutral fed funds rate higher. Conversely, a large decline would suggest that monetary policy is turning restrictive and we should think about calling the cyclical peak in bond yields. Chart 3Tracking The Neutral Rate I Chart 4Tracking The Neutral Rate II Bottom Line: Rather than rely on current estimates of unobservable variables like NAIRU and the neutral rate of interest, investors should monitor developments in the economy and consider how those estimates might evolve over time. For now, investors should expect a rate hike pace of 25 bps per quarter and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Gradualism And The Slope Of The Curve The Fed's fairly explicit guidance that rates will rise by 25 bps per quarter is quite helpful when formulating expectations about the slope of the yield curve. For example, we know that the current 1-year par coupon Treasury yield of 2.35% is priced for exactly 100 bps of rate hikes during the next 12 months with no term premium. In other words, investors today should be indifferent between an investment in cash and an investment in a 1-year Treasury note if they are 100% certain that the Fed will stick to its 25 bps per quarter hike pace for the next 12 months. We can also forecast where the 1-year Treasury yield will be six months from now under a few different scenarios (Table 1). The forward curve is consistent with a 1-year Treasury yield of 2.69% six months from now, and we calculate that it will be 2.83% if the market moves to fully discount a rate hike pace of 25 bps per quarter until the end of 2019. If the market only prices in the Fed's median funds rate projection, which calls for three hikes in 2019, then the 1-year Treasury yield will be between 2.62% and 2.81% six months from now, depending on which meetings in 2019 those three rate hikes are delivered. Table 1Forecasting The 1-Year Treasury Yield The main takeaway from these observations is that even in the most hawkish scenario the 1-year Treasury yield will only rise to 2.83%. This is 48 bps above its current level and a mere 14 bps more than what is already priced into the forward curve. Now let's consider the long-end of the curve. The 10-year and 20-year TIPS breakeven inflation rates currently sit at 2.12% and 2.10%, respectively. If inflation expectations become re-anchored around the Fed's 2% target during the next six months, which we expect they will, then both of these rates will reach a range between 2.3% and 2.5% (Chart 5). This alone will apply between 20 bps and 40 bps of upward pressure to the 20-year Treasury yield. The nominal 20-year Treasury yield is currently 2.98% and the forward curve is priced for it to rise to 3.01% in six months. In the most hawkish scenario where the Fed lifts rates 25 bps per quarter and long-maturity yields remain constant, the 1/20 Treasury slope will flatten by 48 bps during the next six months. In the more likely scenario where Fed rate hikes coincide with the re-anchoring of long-dated inflation expectations, the 1/20 slope will flatten by 28 bps or less. Meanwhile, our model of the 1/7/20 butterfly spread shows that it is priced for 55 bps of 1/20 flattening during the next six months (Chart 6). Or put differently, there is so much extra yield pick-up in the 7-year bullet relative to the duration-matched 1/20 barbell that being long the bullet and short the barbell will be profitable unless the 1/20 slope flattens by more than 55 bps. Chart 5Inflation Expectations Are Still Too Low Chart 6Butterfly Spread Fair Value Model Bottom Line: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be offset by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. Risk Update On May 22 we initiated a tactical long duration position premised on extended net short positioning in the bond market and the high likelihood of negative near-term data surprises.4 We have seen considerable movement in our indicators during the past two weeks - positioning is now much closer to neutral (Chart 7) and our model no longer expects data surprises to turn negative (Chart 8). Therefore, this week we remove our tactical long duration recommendation. The biggest current risk to our below-benchmark duration stance is the large divergence that has opened up between U.S. growth and the rest of the world (Chart 9). This divergence is putting upward pressure on the U.S. dollar and, much like in 2015, is starting to hurt growth in emerging markets, as we discussed last week. Chart 7Bond Market Positioning Chart 8Data Surprises Should Remain Positive Chart 9Foreign Growth Is The Greatest Risk But dollar strength and emerging market weakness is not an imminent threat to higher U.S. yields. Using the 2015 experience as a template, we see in Chart 9 that U.S. yields did not fall until after emerging market financial conditions and global growth had already troughed. In fact, it was not until dollar strength and weak global growth culminated in a dramatic tightening of U.S. financial conditions that the Fed finally signaled a slower pace of rate hikes and Treasury yields declined (Chart 9, bottom panel). Similarly, we don't think the Fed will react to a strong dollar and weak foreign growth until the impact is felt by U.S. risk assets. With U.S. growth still elevated and the dollar having appreciated only modestly so far, we think Treasury yields will avoid this risk during the next few months. Nonetheless, the divergence between U.S. and foreign growth is a risk that bears close monitoring. We will not hesitate to alter our duration stance if the dollar continues to appreciate and the divergence appears close to a breaking point. The Best Time To Move Down In Quality In last week's report we reviewed our assessment of where we stand in the credit cycle. That assessment determines whether we should be overweight or underweight investment grade corporate bonds relative to a duration-equivalent position in Treasuries. This week we zero-in on our allocation to investment grade corporate bonds and consider how we should allocate between the different credit tiers (Aaa, Aa, A and Baa). In next week's report we will look at positioning across the different maturity buckets and industries. We begin our analysis with the four Bond Maps presented in Charts 10-13. These Bond Maps show risk-adjusted return potential on the y-axis. Specifically, the number of months of average spread tightening necessary to achieve the excess return threshold listed in each map's title. The risk-adjusted potential for losses is shown on the x-axis. In this case, it shows the number of months of average spread widening required to underperform Treasuries by the amount listed in the title. Chart 10Investment Grade Corporate Excess Return Bond Map:##br## +/- 50 BPs Threshold Chart 11Investment Grade Corporate Excess Return Bond Map: ##br##+/- 100 BPs Threshold Chart 12Investment Grade Corporate Excess Return Bond Map: ##br##+/- 200 BPs Threshold Chart 13Investment Grade Corporate Excess Return Bond Map:##br## +/- 300 BPs Threshold Credit tiers plotting closer to the bottom-left of the Bond Maps have less potential for return and less risk. Credit tiers plotting closer to the upper-right have greater potential for return and more risk. What we find particularly interesting is that when we set a low return threshold, such as +/- 50 bps, the credit tiers plot almost right on top of each other. In other words, an allocation to Baa-rated corporate bonds gives you a much greater chance of earning 50 bps with about the same risk of losing 50 bps as the other credit tiers. But as we increase the excess return threshold the risk/reward trade-off between the different credit tiers becomes more linear. In Chart 13 we see that Baa-rated bonds have a greater chance of earning 300 bps than the other credit tiers, but also carry a significantly greater risk of losing 300 bps. Chart 14Down-In-Quality Works ##br##Best When Vol Is Low This leads to an interesting conclusion. A macro environment where we would expect low excess return volatility is also one where moving down in quality within investment grade corporate bonds is most beneficial from a risk/reward perspective. Conversely, moving down in quality will improve the risk-adjusted performance of your portfolio by less (and might even hurt the risk-adjusted performance of your portfolio) in a highly volatile return environment. To test this theory, we first recognize that the excess return volatility of the investment grade corporate bond index is tightly linked with its duration-times-spread (DTS). Low DTS environments have lower excess return volatility, and also less of a spread differential between the lower and higher credit tiers (Chart 14). With this in mind we split the historical time series of monthly corporate bond excess returns into four quartiles based on the index DTS (Table 2). We also exclude recessions from our sample, meaning this analysis is only valid during periods of economic recovery. Not surprisingly, the results show that the standard deviation of monthly excess returns increases alongside index DTS. But we also see that the average return advantage in the Baa-rated credit tier is lower when the index DTS is higher. Table 2Investment Grade Corporate Bond Excess Returns By Credit Tier (1989-Present)* When the index DTS is between 3 and 4.5, the reward/risk ratio in the Baa-rated credit tier exceeds the average of the other three credit tiers by 0.13. This advantage falls to 0.07 when the DTS is between 4.5 and 6.7; and falls further to 0.04 when the DTS is between 6.7 and 9.7. In the highest DTS quartile, the Baa-rated credit tier provides a lower reward/risk ratio than the average of the other three credit tiers. At present the index DTS is 8.4. This puts us in the second highest quartile relative to history, and is consistent with a 12-month standard deviation of monthly excess returns of roughly 77 bps for the corporate bond index. In this environment we should expect down-in-quality allocations to positively impact the risk-adjusted performance of a credit portfolio, but not by as much as in lower DTS environments. Bottom Line: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In order to display a longer history, Chart 1 shows the Congressional Budget Office's estimate of NAIRU rather than the Fed's. At present both estimates are very close. The CBO estimates NAIRU to be 4.65% and the Fed's median projection calls for a NAIRU of 4.5%. 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes Chart 7U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment
Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric 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. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 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
Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Feature Chart of the WeekThe Year Of Living Dangerously The latter half of May was a wild wide for global financial markets, which had finally shown signs of healing after the VIX shock from earlier in the year. The cause this time was Italian political turmoil as the populist 5-Star Movement/League coalition attempted to form a government full of fiscal largesse, sprinkled with a hint of euroskepticism. Investors got spooked into thinking that a 2011-style euro "redenomination" (i.e. breakup) risk premium might once again need to be priced into Peripheral government bond yields. The rout in Italian BTPs felt like a classic sovereign debt crisis, emerging markets style. There were even reports of Italian banks providing no price quotes for Italian debt on electronic trading platforms - the 21st Century version of dealers "not answering their phones" during a crisis. All that was missing was an IMF delegation heading to Rome with checkbook in hand. The announcement late last week that the coalition would get another shot at forming a government, rather than throwing Italy into fresh elections that could turn into a referendum on euro membership, restored order to Italian financial markets. The meltdown in Italian yields was almost as rapid as the melt-up, with the 2-year BTP yield ending last week around 1%, almost two full percentage points lower than the peak in yields seen just a few days earlier, but still much higher than the sub-zero yields seen as recently as May 15th. We made a timely decision to cut our recommended stance on Italian debt to underweight two weeks and we are maintaining that call despite the respite from the political turmoil.1 (NOTE: we are putting out a joint Special Report next week with our colleagues at BCA Geopolitical Strategy on June 13th, a day later than our usual Tuesday publishing slot, which will discuss the political outlook for Peripheral Europe and what it potentially means for their bond markets). Our more pessimistic view on Italian bonds was based on our assessment that Italian growth was slowing and would continue to do so. For a country like Italy with a large debt stock and structurally low growth, cyclical downturns always lead to increased worries about debt sustainability. Coming at a time when the ECB is looking to begin the long process of exiting its hyper-easy policies, the growth and monetary backdrop was also becoming more challenging for Italian government bonds. The same thing can be said for the rest of the world. The rapid coordinated acceleration in global growth seen in 2017 has clearly peaked, as has the pace of central bank asset purchases that helped support that recovery through low bond yields (Chart of the Week). The growth convergence has turned into a divergence between growth in the still-strong U.S. and most other major economies. This poses a new threat to financial markets - a rising U.S. dollar - which, combined with some cooling of global growth, is already triggering underperformance of emerging market assets. So after the tumultuous market price action of the past few weeks, we think the most critical potential impact on the direction of bond yields, and our recommended below-benchmark overall portfolio duration stance, can be boiled down to two big questions. Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? NO. The U.S. economy continues to exhibit impressive resilience of late, even as the rest of the world has seen some softening in growth. The Payrolls report for May released last Friday showed another sturdy gain of 223,000 jobs, with upward revisions of 15,000 to the prior two months. This pushed the unemployment rate to 3.8% - the lowest level since April 2000 - while boosting the annual growth in Average Hourly Earnings up to 2.7% (Chart 2). The overall employment/population ratio also inched higher. Both wage growth and the employment/population ratio are well below the peaks seen in the past two business cycles, even with similarly low levels of unemployment. During those cycles, the Fed was forced to raise the funds rate to restrictive levels to cool growth to rein in overshooting inflation. The real fed funds rate was consistently above equilibrium measures like the Williams-Laubach "r-star" (bottom panel), which eventually crimped growth and led to a recession in both cases. In the current cycle, wage inflation is struggling to reach 3% and core PCE inflation at 1.8% has still not returned back to the Fed's 2% target. There is no need for the Fed to push harder on the brakes by raising rates faster than inflation is accelerating and pushing the real rate above r-star. If a growing economy continues to absorb labor market slack, however, the Fed could be chasing a higher level of r-star to prevent inflation from continuing to accelerate (bottom panel). Looking ahead, it does look like the Fed will continue to play a bit of catch-up to an accelerating U.S. economy. Leading economic indicators (both from the OECD and Conference Board), as well as our forward-looking models for employment and capital spending, all point to faster growth in the next couple of quarters (Chart 3). This will only support the case for the Fed to continue with its current rate "measured" pace of one rate hike per quarter over the next year. Chart 2Labor Market Tightening##BR##Leads To Fed Tightening Chart 3U.S. Growth Still##BR##In Good Shape With the U.S. dollar now reconnecting to the widening interest rate differentials between the U.S. and other major economies, there is a risk that the implied tightening of monetary conditions from a higher greenback could limit the need for the Fed to continue with its rate hike plans. Yet at the moment, the trade-weighted dollar is still not accelerating on a year-over-year basis, in contrast to the +15% appreciation seen during the 2014/15 dollar bull run (Chart 4). At the peak of that episode, net exports were a drag on real GDP growth of -1% and headline CPI inflation hit 0% (aided by collapsing oil prices). While an appreciation of that magnitude is unlikely, it would still take a much larger increase in the dollar to meaningfully dent growth in a way that could cause the Fed to pause on the rate hikes. A bigger dollar rally could also raise financial instability, primarily by hitting emerging markets where currency weakness versus the dollar would trigger tighter monetary policy and slower growth. That is certainly a risk for the Fed to consider. Yet given the underlying strength of the U.S. economy today, the Fed would only react to any turmoil in emerging markets if it meaningfully impacted U.S. financial markets, but not before then. While the Fed is still likely to continue on its rate hike path over the rest of 2018, the market has largely discounted that outcome - even after the late May decline in U.S. interest rates on the back of Italy-fueled risk-aversion (Chart 5). The market is still not completely priced to the Fed's interest rate projections over the next year, however, which does raise the potential for a return to the +3% level on the 10-year U.S. Treasury yield that was seen before the Italy crisis flared up. However, our colleagues at our sister publication, BCA U.S. Bond Strategy, continue to point out the risks to a continued near-term period of declining (or at least, consolidating) Treasury yields given persistent short positioning in the Treasury market at a time of slowing data surprises (Chart 6). We remain bearish on Treasuries over a strategic horizon, however. Chart 4USD Rally Not Yet##BR##Enough To Impact The U.S. Chart 5Market Still Priced Close To##BR##The Fed's Interest Rate Projections Chart 6UST Yields Likely To##BR##Consolidate In The Near-Term Bottom Line: U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? PROBABLY NOT. The latest volatility in European financial markets stemming from the Italy crisis came at a difficult time for the ECB. The central bank has been incrementally preparing the market for an eventual tapering of its asset purchase program after it expires in September. Yet the slowdown in euro area growth in the first quarter of the year, amid sluggish readings on inflation, has raised some doubt that the ECB would even be able to announce any sort of withdrawal of monetary stimulus. Chart 7Market Buying Into The ECB's##BR##'Low Rates For Longer' Message It is now a consensus expectation that the ECB will taper its net new asset purchases fully to zero by the end of 2018. What has moved, however, is the market's expectation for the timing of the first rate hike by the ECB. That has now been pushed out to April 2020 after the Italy turbulence (Chart 7). The ECB has been consistently signaling to the markets that it views the two decisions - tapering and rate hikes - as separate choices to make. In other words, tapering does not mean that rate hikes will come soon afterward. So far, the market appears to be listening to the ECB's signals by moving out the timing of any rate hike to nearly two full years from today. Given the magnitude of the slide in euro area growth seen in the first few months of 2018 (2nd panel), that may be taken as a sign that the market thinks the slump can continue. This also is consistent with the market believing the ECB's views on seeing through any impact on euro area inflation from changes in oil prices and the euro. The annual growth of the Brent oil price, in euro terms, has climbed to nearly 50% over the past few months (3rd panel). There has always been a strong correlation of that growth rate to overall headline euro area inflation, as evidenced by the early read on May CPI inflation released last week that came in at 1.9%. Yet core CPI inflation in the euro area is still only 1.1%, well below the ECB's inflation target of "just below" 2%. Market-based inflation expectations are still below the level as well, with the 5-year euro CPI swap, 5-years forward now sitting at 1.7%. So the market pricing is consistent with an ECB that will be very slow to begin raising interest rates. That would also be consistent with the behavior of the ECB when it comes to its past tightening cycles. In Chart 8, we show diffusion indices at a country level for euro area industrial production growth (as a proxy for economic growth), headline inflation and core inflation. These show the percentage of all euro area countries that are seeing accelerating growth or inflation versus those countries seeing slowing growth and inflation. A higher diffusion index means that any acceleration in growth or inflation is broad-based, and vice versa. Chart 8ECB Rate Hikes Happen During Broad-Based Inflation Upturns As can be seen in the chart, the ECB's past tightening cycles since the beginning of the euro in 1998 have all occurred when the diffusion indices for inflation have risen into the 60-80% zone. In other words, the ECB is more aggressive on lifting rates when a large majority of countries in the euro zone is seeing accelerating inflation. During those same tightening cycles, however, the diffusion indices for growth have been decelerating, suggesting less broad-based economic strength. The implication from this analysis is that the ECB cares more about inflation than growth when making its monetary policy decisions. The ECB's reputation for sometimes making overly hawkish policy mistakes, like in 2010-11, is well deserved. Looking ahead, the current readings on the diffusion indices for both growth and, more importantly, inflation are all quite depressed. This suggest that the slowing growth seen in the overall euro area data so far in 2018 has been broad-based, while the increase in the overall euro area inflation data has not been broad-based. This can be seen when looking at the some of the individual country data for the major core euro area countries (Chart 9) and Peripheral countries (Chart 10). For example, Netherlands and Portugal stand out as having inflation trends that are much weaker than the other countries. Yet the more divergent trends in euro area inflation does not mean that the ECB will decide to defer any decision to taper, however. The ECB will have to make that decision at either the June or July meetings, with the current program set to end in September. Absent a significant drop in euro area inflation, the ECB is still likely to signal a full taper by the end of the year. Yet even if they did extend the current program into 2019, at the same pace of 30 billion euros per month, this would likely not have a meaningful impact on the level of euro area bond yields. We have found that is the growth rate of those purchases, and not the absolute level, that is most correlated to the level of euro area bond yields (Chart 11). Even if the current program were to be extended to March 2019, to be followed by a tapering of net purchases to zero by September 2019, then the annual growth rate of the ECB's balance sheet (driven by the asset purchases) would remain mired below 10% - a far slower pace compared to the peak years of ECB bond buying. Chart 9Growth Convergence,##BR##Inflation Divergence In Core Europe... Chart 10And In##BR##Peripheral Europe Chart 11Extending ECB Bond Purchases##BR##Into 2019 Would Have Limited Impact In other words, an extension of the asset purchases would not drive euro area bond yields any lower, and would entail operational constraints on country sizes, etc. The ECB will have better success at driving down yields by keeping policy rates lower for longer, as it is signaling it will do. Bottom Line: The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns