Asset Allocation
Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-Ã -vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. 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-20 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##Br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Chart 3Consumer Spending And##BR##Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Chart 9High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.
Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation
Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations