Monetary
Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong Chart I-2BMedium Expansions Chart I-2CA Short Expansion Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Chart III-5BJapanese Vs. U.S. Fundamentals... Chart III-6RoE Is Consistently Lower In Japan Table III-1Japanese Vs. U.S. Sector Weights The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) Chart III-7BMechanical Valuation Indicators (I) Chart III-7CMechanical Valuation Indicators (I) Chart III-7DMechanical Valuation Indicators (I) Chart III-8AMechanical Valuation Indicators (II) Chart III-8BMechanical Valuation Indicators (II) Chart III-8CMechanical Valuation Indicators (II) The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.
Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome Chart 4Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives Chart 16An Inflationary Backdrop Chart 17Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.
Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall Chart I-12China Is The Giant In The Room The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals Chart I-14Better Supply/Demand Backdrop For Oil We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump Chart I-16European Labor Market##br## Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights All three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are dollar bullish. The implementation of these policies could cause the U.S. economy to overheat, forcing the Fed to raise rates more than it otherwise would. A Trump presidency is unlikely to lead to major institutional changes at the Fed. Trump is okay with a stronger dollar and higher rates, as long as these do not cause growth to stall. Investors have gone from too bearish to too bullish about what a Trump victory means for equities. A tactically cautious stance is still appropriate. Feature Trump Triumphant Chart 1Trumpism Trumps Unfavorability The late film critic Pauline Kael allegedly once said that there was no way that Richard Nixon could have won the 1972 election because she didn't know a single person who voted for him. Kael actually never said this, but the story rings true because one can imagine many people saying something like that. I spent the last few days meeting clients in New York City. The expression on the faces of people while walking down the streets in Manhattan - which went 87%-to-10% for Clinton over Trump - said it all. Most people seemed dazed and confused by what happened on November 8th. Trump did not win because of his personality. He won in spite of it. As I have emphasized over the past 18 months - starting with my presentation at the 2015 BCA New York Conference, which featured the prediction that "The Trumpists Will Win" - Trumpism is a lot more popular than Trump. How else can someone with a 62% unfavorability rating become the next president of the United States (Chart 1)? The reason that Trump won is because he addressed many of the legitimate grievances of blue collar workers in swing states that establishment politicians had long ignored. As we discussed last year in a report entitled "Trumponomics: What Investors Need To Know,"1 trade with China has led to a hollowing out of the U.S. manufacturing base; low-skilled immigration has dragged down blue collar wages; and the flow of drugs into the U.S. from across the southern border is a legitimate problem. Donald Trump And The Markets I will have much more to say about the long-term economic and political consequences of Trump's victory in a special report that I intend to publish next week. For now, however, let me concentrate on the near-term investment implications. Global equities plunged in the immediate aftermath of the election results, while the dollar weakened and Treasurys rallied. This knee-jerk reaction largely stemmed from the fear that a Trump presidency would be highly destabilizing for the global economy. In such an environment, the Fed would not be able to raise rates very much, which is a clear negative for the greenback. Trump's conciliatory victory speech helped soothe frayed nerves, sending both the dollar and Treasury yields higher. This was consistent with our expectations. As we argued in "A Trump Victory Would Be Bullish For The Dollar" and in "Three New Controversial Calls: Trump Wins And The Dollar Rallies," all three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are bullish for the dollar and bearish for bonds.2 Fiscal Stimulus On The Horizon Now that Donald Trump has a Republican House and Senate to work with, there is a high probability that he will be able to push through a sizable infrastructure bill (sidebar: I am writing these words from the Kabul-like departure area at LaGuardia airport. My flight to Montreal is delayed because Trump's plane, which he dubs Trump Force One, will be taking off soon). In addition to increasing infrastructure spending, Trump has pledged to raise defense expenditures and enact sizable tax cuts. The Tax Policy Center estimates that Trump's tax plan alone would increase the federal debt by $6.2 trillion over the next ten years (excluding additional interest), representing approximately 2.6% of GDP of fiscal stimulus per year.3 We doubt that Congress will approve anything close to that. Nevertheless, even if he gets one quarter of the revenue and expenditure measures that he is seeking, this would be enough to boost aggregate demand growth by 0.5%-to-1% per year over the next two years. Pulling Back The Welcome Mat Chart 2Trump's Hard Line On Trade ##br##And Illegal Immigration Would##br## Benefit Low-Skilled Workers Immigration policy is one of those areas where the president can do a lot without congressional approval. Existing U.S. immigration laws are already very strict; they just happen to be enforced in a highly haphazard manner. High-skilled workers who want to go through the proper legal channels to gain residency must jump through all sorts of burdensome hoops; in contrast, low-skilled workers who enter the country illegally can generally evade detection and prosecution. This obviously makes for a suboptimal immigration system. Trump's campaign rhetoric has generally focused on combating illegal immigration. Although his official immigration policy paper - allegedly ghost-written by Senator Jeff Sessions - mentions cutting back on high-skill H1-B visas, at times Trump has appeared to disavow that view, stressing his desire to bring in only "the best" immigrants. Our suspicion is that a Trump presidency would generally take a fairly soft stance towards high-skilled immigrants, focusing instead on curbing illegal immigration through increased border security and the rollout of a mandatory national E-Verify system. Since illegal immigrants are generally poorly educated, such an outcome would raise the wages of low-skilled workers. Chart 2 shows that the pool of unemployed low-skilled workers has largely evaporated in recent years. Higher wage growth, in turn, could cause the Fed to hike rates more aggressively than it otherwise would, helping to push up the value of the dollar. Protectionism And The Dollar As with immigration, the executive branch has a lot of discretion over trade policy. There is an ongoing debate about whether sitting presidents can withdraw from trade deals that they do not like without congressional approval. The prevailing legal view is that they can, but even if that turns out not to be the case, they can certainly take other measures that increase import barriers. Such tactics have often been used by Republican presidents who liked to portray themselves as free traders. For instance, Ronald Reagan imposed voluntary export restraints on Japanese automakers and major foreign steel producers, raised tariffs on Japanese motorcycles, and tightened quotas on sugar imports. George W. Bush also increased tariffs on steel imports and imposed quotas on Chinese textiles. It goes without saying that Donald Trump would not be averse to taking similar steps. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. This could help reduce the U.S. trade deficit. A smaller trade deficit, in turn, would increase aggregate demand. This, in conjunction with the adverse supply-side effects that protectionist measures typically result in, would cause the output gap to narrow further, forcing the Fed to step up the pace of rate hikes. In addition, standard trade theory suggests that higher trade barriers would raise real wages for low-skilled workers. Since such workers tend to have the highest marginal propensity to consume, this, too, would boost aggregate demand. Trump And The Fed While Trump's policy proposals are all dollar bullish and bond bearish, where does Trump himself want the dollar and bond yields to go? The answer will obviously influence his relationship with the Fed and how he responds to any dollar strength. As with many of his policy ideas, it is hard to know exactly where Trump stands. Investors are accustomed to politicians who constantly flip-flop on the issues. Trump takes it a step further. He may be the first "quantum" candidate to run for office: Just like an electron can have a different spin and position at the same time, Trump seems capable of believing multiple things at the same time and spinning any position to his liking. With that caveat in mind, we think that a Trump presidency would not represent a significant departure from existing monetary policy. While Trump has said that he would like to replace Janet Yellen with a Republican once her term expires in 2018, he has also said he has "great respect" for the Fed Chair, and that he is "not a person who thinks Janet Yellen is doing a bad job." As far as the direction of interest rates is concerned, Trump has acknowledged that "as a real estate person, I always like low interest rates," but "from the country's standpoint, I'm just not sure it's a very good thing, because I really do believe we're creating a bubble." Chart 3Still Below Past Peaks He also seemed to acknowledge that there is a limit to how strong the dollar can get. "If we raise interest rates," he said, "and if the dollar starts getting too strong, we're going to have some very major problems." Our conclusion is that Trump would welcome higher rates, so long as any dollar appreciation does not choke off growth. As we discussed last month in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the combination of a rebound in business capex, less inventory destocking, and continued strong personal consumption growth thanks to rising wages could cause aggregate demand growth to rise to 2.5%-to-3% this year.4 Trump's victory increases the risk to these numbers to the upside. Since we published that report, the broad real trade-weighted dollar has gained about 1.5%. We are still comfortable with our view that the dollar will rise by another 8.5% over the next 11 months. As Chart 3 shows, this would still leave the greenback below its previous 1985 and 2001 highs. Trump And Other Central Banks A more difficult issue to handicap is how a Trump presidency will influence policy outside the U.S. Would China, for example, feel the need to prop up the RMB in order to avoid Trump's wrath? Would Japan be less willing to pursue an accommodative monetary policy in an indirect effort to weaken the yen, if this led to the threat of higher tariffs on Japanese exports to the U.S.? Our sense is that yes, a Trump administration will, to some extent, constrain the ability of other nations to weaken their currencies. That said, the impact is unlikely to be especially dramatic. China does manipulate its currency. But lately it has been selling foreign-exchange reserves in an effort to keep the RMB from falling more than it otherwise would. Thus, an end to China's intervention would mean a weaker yuan, not a stronger one. Likewise, as long as the Bank of Japan is not engaged in direct foreign asset purchases, the ability of the Trump administration to cry foul is limited. Equity Implications We must admit that we are surprised that global equities were so quick to shrug off their losses. Our expectation had been that stocks would weaken somewhat in the wake of a Trump victory. What happened? A few things come to mind. First, there has probably been a fair amount of short-covering from investors who had bought insurance against a Trump win. Second, investors, like all humans, tend to draw on analogies in making their decisions. The best analogy for what happened on November 8th is what occurred after the Brexit vote. The lesson from that episode is that one should buy stocks after a supposedly negative voting outcome. That is exactly what investors did Wednesday morning. Third, there are in fact some legitimate reasons why President Trump may be good for stocks. In addition to the prospect of lower corporate tax rates and fiscal stimulus, a Trump administration is likely to go soft on financial regulation. This, in tandem with a steeper yield curve, could prove to be a positive development for banks. A Trump administration is also good news for energy companies, particularly coal. Defense contractors should benefit from increased military expenditures. The implications for health care stocks is harder to gauge. While the potential repeal of the Affordable Care Act could hurt some companies, it may benefit others. Our hunch is that the net effect for health care earnings will be positive. Even if Obamacare is repealed, it is likely to be replaced with something that looks a lot like the existing legislation, just with more subsidies and giveaways for health care providers and drugmakers (think of Medicare Part D). Having said all this, investors now seem to be a bit too complacent about what a Trump presidency means for stocks. The risk of a trade war is still present. And even if Trump pulls in his protectionist horns, a tighter labor market, exacerbated by a potential shortage of immigrant workers, is likely to eat into corporate profit margins. Higher rates and a stronger dollar will also hurt. As such, we are maintaining our tactically cautious stance on global equities. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," (Call #1: Trump Wins, And The Dollar Rallies), dated September 30, 2016, available at gis.bcaresearch.com. 3 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The credibility of ECB QE is set to diminish, one way or another. Stay long euro/dollar. Expect a continued compression in the German Bund yield spread versus the U.S. T-bond. Until the U.K. Supreme Court provides further legal clarity about the Brexit process, expectations for a softer Brexit should prop up the pound. In which case, the Eurostoxx600 will outperform the FTSE100 and the FTSE250 will outperform the FTSE100. Feature Nobody saw Brexit coming on June 23, and few saw a President Trump coming on November 8. Just as in the days after June 23, financial markets are trying to regain a footing after another political earthquake. The dust will settle. Our geopolitical strategists will provide a post-election analysis in a separate report. In this report, we would like to look through the immediate haze and focus on three major institutions whose policy options and degrees of freedom were becoming constrained, irrespective of the U.S. election shock. The institutions are: the ECB, the Federal Reserve, and the U.K. government. Chart of the WeekExpected Policy Rate Differential Drives ##br##The German Bund Yield Spread Versus The U.S. T-Bond The ECB Is Facing A Lose-Lose Decision Central bank quantitative easing (QE) remains one of the most misunderstood concepts within economics and finance. Contrary to the popular myth, it is not the central bank's asset purchases per se that matter. If the central bank's act of buying assets works at all, it is because QE signals a long period of ultra-low interest rates ahead.1 This then reduces the yields on other financial assets through the so-called "portfolio balance channel." Chart I-2Through 2011-13 Markets Interpreted A Lower ##br##Flow Of QE As A Monetary Tightening As Fed Chair Janet Yellen succinctly explains, once there is ample liquidity in the banking system: "QE has no discernible economic effects aside from those associated with communicating the central bank's commitment to the zero interest rate policy" The fundamental point is that the precise amount and asset-class composition of a QE program does not matter. The program just has to be large enough to demonstrate a credible commitment to ultra-low rates. But once a central bank establishes a monthly purchase amount, for example, the current €80bn for the ECB, the flow becomes an anchor. Financial markets then interpret a decrease in that monthly flow as a weakening commitment to ultra-low rates: in effect, a monetary tightening (Chart I-2). On the other hand, if the monthly asset-purchase promise goes on indefinitely, it also loses credibility. The financial markets know full well that there is only a finite pool of safe-assets that the central bank can buy, as the recent experience of the Bank of Japan testifies. For the ECB, the so-called "degrees of freedom" are even more limited than for the Bank of Japan. Asset purchases are constrained by politically determined upper-limits to individual euro area country exposure and by liquidity determined upper-limits to individual financial asset exposure. Hence, the ECB now faces a lose-lose decision. If it signals an intention - even a delayed intention - to taper its €80bn monthly flow of QE, the financial markets will interpret it as a de facto tightening. But if it does not signal an intention to taper it will have to use more and more smoke, mirrors, and chicanery to justify how it can keep delivering on its promise to buy. Bottom Line: one way or another, the credibility of ECB QE is set to diminish. The Federal Reserve's Track Record In Predicting Its Own Policy Is Abysmal To take a position on the euro/dollar exchange rate or the yield differential between German Bunds and U.S. T-bonds, we must now consider the other central bank in the equation: the U.S. Federal Reserve. When it comes to predicting the stance of its own monetary policy, the track record of the Federal Reserve is nothing short of abysmal. The Federal Reserve's famous dot forecasts have consistently missed the mark. In fact, they have not even come close to the mark. Just two years ago, the median Fed dot was predicting ten rate hikes by now (Chart I-3). Yes, seriously - ten! Chart I-3Two Years Ago, The Median Fed Dot Was Predicting Ten Rate Hikes By Now In its own defence, the Fed might respond that its monetary policy is "data-dependent" or even "events-dependent", and that this contingency prevented it from hiking the ten times that it had forecast. That's fine. But it then raises a bigger question about credibility. If central bank policy is contingent, then is it really possible to give credible forward guidance on the level of interest rates stretching out years ahead? We think not. Indeed, by publishing dots that turn out to be so consistently and deeply wrong, the central bank is seriously damaging its own credibility and authority. Rather than relying on Federal Reserve dots or market forecasts, investors must make up their own minds about the likely path of the Fed funds rate. For bond investors, the medium-term question is: at what level will the policy rate peak in this tightening cycle? This is because at the peak of the tightening cycle, the 0-10 year yield curve tends to be more or less flat (Chart I-4). In other words, the 10-year bond yield ends up eventually trading at the same level at which the policy rate peaks. After the election shock, the knee-jerk response has been a higher 10-year T-bond yield, and this direction may continue in the near-term. But further out, the question is: will the Fed funds rate peak above or below where today's 10-year T-bond yield of 1.9% implies that it will peak? We think below. Note that a first and second interest rate hike interspersed by a full year is unprecedented in modern economic history. And now, even the intended second hike in December might be in jeopardy. Given that the Fed has struggled to get two 25bps hikes through in two years, the idea that it will succeed in hiking another four or five times in this tightening cycle really does not seem credible to us. Bottom Line: Combined with the diminishing credibility of ECB QE, stay long euro/dollar (Chart I-5); and expect a continued compression in the German Bund yield spread versus the U.S. T-bond. In other words, maintain the pair-trade: long T-bonds, short German bunds (currency hedged) (Chart of the Week). Chart I-4At The Peak Of A Tightening Cycle, ##br##The 0-10 Year Yield Curve Is Flat Chart I-5Expected Policy Rate Differential##br## Drives Euro/Dollar The U.K. Government Has Had Its Wings Clipped The U.K. Government is another institution that has suffered a huge blow to its credibility and authority. Prime Minister Theresa May brazenly thought that she could start the legal process to exit the EU using the so-called 'royal prerogative', the power granted to governments to make certain decisions without a vote from parliament. But as we presciently warned two weeks ago in The Pound: Next Stop $1.10 Or $1.35,2 the U.K. High Court has judged the government does not have the authority to overturn domestic law - in this case, the European Communities Act (1972) and European Union Act (2011) - without obtaining parliamentary approval. The irony is that the sovereignty of the U.K. Parliament is the very thing that Brexiteers supposedly are fighting for. The High Court has clipped the U.K. Government's wings by deferring the Article 50 trigger to parliament. The government is appealing the High Court decision at the Supreme Court whose verdict is expected in January. But given that the government itself concedes that the Article 50 trigger will irrevocably change domestic law, it is hard to see how the government will win the appeal. Hence, there is a high likelihood that Members of Parliament will get to scrutinise the government's negotiating hand before it is allowed to fire the Brexit starting gun. Given that the precise form of Brexit has huge implications for British people's economic future and legal rights, parliament could water down or delay Brexit before voting it through. Bottom Line: Until the Supreme Court provides further legal clarity3 in January, expectations for a softer Brexit should prop up the pound. In which case: the Eurostoxx600 will outperform the FTSE100; the FTSE250 will outperform the FTSE100; U.K. retailers, travel and real estate equities will outperform the U.K. market; but U.K. goods exporters will underperform (Chart I-6 and Chart I-7). Chart I-6A Soft Or Hard ##br##Brexit... Chart I-7...Determines The Prospects ##br##For Most U.K. Assets Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Because while an asset-purchase program is underway, it would be difficult to raise rates. 2 Published on October 27 2016 and available at eis.bcaresearch.com 3 The Supreme Court will judge the government's appeal against the High Court decision. If the appeal is lost, it may also judge what type of parliamentary approval is required to trigger Article 50: a full Bill or a simple Resolution. Fractal Trading Model* This week's recommended trade is to go long U.K. healthcare versus the market. 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-8 * 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 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. 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