BCA Indicators/Model
Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) Chart 10Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps
Yesterday’s FOMC press statement was largely unchanged from the previous release. The Fed left rates unchanged as expected, but is likely to deliver another hike in December. Despite October’s market turbulence, Fed officials still view interest rates as…
Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of October 31, 2018. The quant model downgraded U.S. and Italy to underweight from overweight while upgrading Canada to a slight overweight from underweight, largely due to changes in technical and valuation conditions. Now the model is overweight 5 countries (Netherland, Germany, Spain, Switzerland and Canada) and underweight 7 countries (Japan, U.S., U.K., France, Australia, Sweden and Italy), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, both Level 1 and Level 2 of the model system outperformed in October by 6bps and 57 bps, respectively, resulting in an outperformance of 24 bps from the overall model. Since going live, the overall model has outperformed its benchmarks by 44 bps, driven by Level 2 outperformance of 121 bps and Level 1 outperformance of 2bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. 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 Dear Client, As advised last month, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understand will be in December. We thank you for your understanding.
Highlights Duration Strategy: The recent market turmoil was a long overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. Country Allocations: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Feature Repricing "Central Banker Puts" Can Be Painful By a quirk of our scheduling, we have not published a regular Weekly Report since September, during what became a period of more turbulent global financial markets. While we trust that our clients have enjoyed the Special Reports that we have published instead, we are certain that many are asking an obvious question: have the more jittery markets triggered any change in BCA's views on global fixed income? The answer is "no". Just like the sharp "Vol-mageddon" risk asset selloff back in early February, the origin of the recent volatility spike was soaring U.S. Treasury yields driven by a rapid upward revision of Fed rate hike expectations (Chart of the Week). We had been expecting such an adjustment based on our positive assessment of the underlying momentum of both economic growth and inflation in the U.S. This remains a critical underpinning for our below-benchmark call on U.S. duration exposure, and our increased caution on U.S. spread product. Chart of the WeekRisk Assets Struggling As Bond Yields Rise There is more to the story than just the Fed, however. Throughout the course of 2018, we have been warning that global central banks moving away from accommodative monetary policies would be the greatest threat to market stability. This is not only a story of Fed rate hikes. A reduction in the pace of asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), combined with outright contraction of the Fed's swollen balance sheet, has created a backdrop more conducive to volatile spikes - especially if the global economy is losing upward momentum at the same time. The OECD leading economic indicator has been steadily declining throughout 2018, a reflection of the more challenging backdrop for non-U.S. growth. It is no coincidence that, without the support from accelerating liquidity or positive economic momentum, many of last year's best performing investments (Italian government bonds, the Turkish lira, Emerging Market (EM) hard currency corporate debt) have been some of 2018's worst (Chart 2). Investors were willing to ignore the poor structural fundamentals underlying those markets when times were good, but have been much more cautious in 2018 with a less supportive macro environment. Chart 2The Darlings Of 2017 Are The Duds Of 2018 While there have been numerous political headlines that have caused bouts of market turbulence in the past few months - the escalating U.S.-China "tariff war", the Italian fiscal debate with the European Union - the short-term impact of these moves is magnified when global monetary policy is being tightened and global growth is cooling. The reason why central banks have been forced to turn more hawkish (or at least less dovish) is that diminished economic slack has forced their hands. For policymakers with an inflation-targeting mandate, the Phillips curve framework remains the primary analytical framework. When they see low unemployment, they get nervous. When they see low unemployment AND rising inflation, then become hawkish. Three-quarters of OECD countries now have an unemployment rate below the estimate of the full-employment NAIRU - the highest level in a decade - and realized inflation rates are accelerating in the major developed economies (Chart 3). Our own Central Bank Monitors are signaling the need for tighter monetary policy in most countries, while yields at the front-ends of government bond curves are steadily rising. Chart 3Central Bankers Still Believe In The Phillips Curve Looking ahead, we continue to see more upward pressure on global bond yields in the next 6-12 months. Market pricing for the future policy actions of the major central bank did not move much even with the surge in volatility earlier this month. The markets now understand that the "policymaker put" that central bankers have implicitly sold to investors has a much lower strike price when labor markets are tight and inflation is accelerating. It will take much larger selloffs to cause central banks to become less hawkish. We still see the decisions we made in late June, moving to a more cautious recommended stance on overall risk in fixed income portfolios, as appropriate. Staying below-benchmark on overall global duration risk, while underweighting those countries where the central banks are under the greatest pressure to tighten policy, is the most sensible way to allocate a fully-investment government bond portfolio. That means underweighting the U.S. and Canada and overweighting Japan, Australia and the U.K. (Chart 4). In terms of credit, we are maintaining an overall neutral stance, but favoring the U.S. versus European equivalents and a maximum underweight on EM credit. Chart 4Interest Rates Remain Unfazed By More Jittery Markets Bottom Line: The recent market turmoil was a long-overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. The Most Important Charts For Our Most Important Country Duration Views When determining our recommended fixed income country allocation, there are a few critical indicators we are watching to assess if those views should be maintained. We now go over each of those indicators for the most important developed economy bond markets: U.S. (Underweight): Watch TIPS Breakevens & The Employment/Population Ratio U.S. Treasuries have been the one major government bond market this year that has seen a rise in both inflation expectations and real yields. The breakeven inflation rate implied by the spread between 10-year nominal Treasuries and TIPS has gone up from 1.97% to 2.10% since the start of 2018, while the real 10-year TIPS yield has climbed from 0.44% to 1.09% over the same period. The rise in inflation expectations has occurred alongside an acceleration of U.S. economic growth and a generalized rise in inflation pressures. Reliable cyclical leading indicators like the ISM Manufacturing index and the New York Fed's Underlying Inflation Gauge are pointing to an acceleration of U.S. core CPI inflation towards the 2.5-3% range over the next year (Chart 5). This would be enough to push 10-year TIPS breakevens comfortably into the 2.3-2.5% range that we deem consistent with the Fed's price stability target (core PCE inflation at 2%). Chart 5U.S.: Both Real Yields & Inflation Expectations Are Rising Any larger move in inflation expectations would only occur if the Fed were to accommodate it by not continuing to hike rates at the current 25bps/quarter pace. That is unlikely with the strength of the U.S. labor market suggesting that the Fed is behind the curve on rate hikes. The U.S. employment/population ratio for prime age (25-54 years old) workers has almost returned back to the peak levels of the mid-2000s near 80% (bottom panel). The Fed had to push the real funds rate to over 3% during that cycle to get policy to a restrictive setting above the Fed's estimate of the r-star neutral real rate. While it is unlikely that the Fed will need to push the real funds rate to as high a level as in the mid-2000s, the current real rate has not even caught up to the Fed's r-star estimate, which is starting to slowly increase alongside the stronger U.S. economy. That implies a higher nominal funds rate would be needed to push up the real rate to neutral levels, with even more nominal increases needed if inflation continues to accelerate. With only 62bps of rate hikes over the next year currently discounted in the USD Overnight Index Swap (OIS) curve, there is scope for Treasury yields to rise further over the next 6-12 months. Core Europe (Underweight): Watch Realized Inflation Relative to ECB Forecasts In the euro area, the evolution of unemployment, wage growth and core inflation compared to the ECB's positive forecasts will be the critical driver of the future direction of government bond yields. In its latest set of economic projections published last month, the ECB expects the overall euro area unemployment rate to be 8.3% in 2018, 7.8% in 2019 and 7.4% in 2020.1 With the actual unemployment rate falling to 8.1% in August, the realized outcomes are already exceeding the ECB's forecasts (Chart 6). The same can be said for euro area wages, where the growth in compensation per employee (2.45%) is already running above the 2018 ECB projection of 2.2%. The ECB expects no acceleration of wage growth in 2019 (2.2%), but a further ratcheting up in 2020 (2.7%). Chart 6Euro Area: Expect Higher Yields If ECB Forecasts Materialize In a recent Special Report, we identified a leading relationship between wage growth and core HICP inflation in the euro area of around nine months.2 This would suggest that core HICP inflation should rise towards 1.5% within the next six months based on the current acceleration of wage growth (second panel). This would be above the ECB's current projection for 2018 (1.1%), but in line with the 2019 forecast (1.5%). Core inflation is projected to rise to 1.8% in 2020. If unemployment and inflation even just match the ECB's forecasts, there is likely to be a material repricing of core European bond yields through higher inflation expectations. At 1.7%, 10-year EUR CPI swaps are well below the +2% levels that occurred during the past two ECB rate hike cycles in the mid-2000s and 2010-11 (third panel). Both wage and core price inflation in the euro area were around the ECB's current 2019-2020 projections during both of those prior tightening episodes, suggesting that the past may indeed be prologue when it comes to inflation expectations. Given growing U.S.-China trade tensions, and uncertainties over the future path for Chinese economic growth, there is a risk that the ECB's growth and unemployment forecasts are too optimistic. The euro area economy remains highly levered to exports, and to Chinese demand in particular. Furthermore, the ECB continues to provide very dovish forward guidance, with no rate hikes expected until at least September 2019. Yet with a mere 12bps of rate hikes over the next year currently discounted in the EUR OIS curve, there is scope for core European bond yields to rise further over the next 6-12 months if euro area inflation surprises to the upside. Italy (Underweight): Watch Non-Italian Bond Spreads & The Euro The Italian budget battle with the European Union has been a gripping drama for investors in recent months. Italian bond yields have been under steady upward pressure, with the benchmark 10-year yield getting as high as 3.78%. Yet the story remains as much about sluggish Italian growth as it is about Italian fiscal policy. The populist Italian government has pushed for larger deficits, but has toned down the anti-euro language that dominated the election campaign earlier this year. This is why there has been very minimal contagion from higher Italian bond yields into other Peripheral European bond yields or euro area corporate bond spreads, or into the euro itself which remains very firm on a trade-weighted basis (Chart 7). Chart 7Italy: A Story Of Weak Growth, Not Euro Break-Up We continue to view Italian government bonds as a growth-sensitive credit instrument, like corporate bonds. In other words, faster Italian economic growth implies greater tax revenues, smaller budget deficits and a less worrisome trajectory for Italy's debt/GDP ratio. The opposite holds true when Italian economic growth is slowing. This is why there is a reliable directional relationship between Italy-Germany bond yield spreads and the OECD's leading economic indicator (LEI) for Italy (top panel). With the Italy LEI still in a downtrend, we do not yet see a cyclical case for shifting away from an underweight stance on Italian government bonds. Yet if the 10-year Italian yield were to reach 4%, the implied mark-to-market loss would wipe out the capital of Italy's banks, who own large quantities of government bonds. In that scenario, the ECB would likely get involved to stem the crisis, possibly by further delaying rate hikes of ramping up asset purchases. This would especially be likely if there was significant widening of non-Italian credit spreads and a sharply weaker euro. Hence, watch those markets for signs that the Italy fiscal crisis could trigger a monetary policy response. U.K. (Overweight): Watch Real Wage Growth & Business Confidence In the U.K., our non-consensus call to stay overweight Gilts has not been based on any long-run value considerations. Real yields remain depressed and the Bank of England (BoE) has kept monetary policy settings at extremely accommodative levels. The BoE continues to expect that a rise in real wage growth is likely due to the very tight U.K. labor market. This would support consumer spending and eventually require higher interest rates. The only problem is that this is happening very slowly. The annual growth in U.K. wage growth is now up to 3.1%, the fastest rate since 2008. This is above the pace of headline CPI inflation of 2.5%, thus real wages are finally starting to perk up (Chart 8). A continuation of this trend would feed into faster consumer spending and, eventually, trigger BoE rate hikes. Chart 8U.K.: Brexit Uncertainty + Middling Inflation = BoE Doing Little One other big impediment to the BoE turning more hawkish is the uncertainty over the U.K. government's Brexit negotiations with the EU. The extended Brexit drama has weighed on both U.K. business and consumer confidence, both of which have struggled since the 2016 Brexit vote (third panel). With the March 2019 deadline for the U.K. "officially" leaving the EU fast approaching, the odds of no deal being reached in time are increasing. U.K. Prime Minister Theresa May is desperately trying to avoid a no-deal Brexit, but such an outcome would create further instability in U.K. financial markets and close any near-term window of opportunity for the BoE to try and hike rates. For now, we see the depressed confidence from Brexit uncertainty offsetting the bump up in real wage growth, leaving Gilts on a path to continue modestly outperforming as they have throughout 2018 (bottom panel). An announcement of a Brexit deal would be a likely trigger for us to downgrade Gilts to neutral, and perhaps even to underweight given the developing uptrend in real wage growth. Bottom Line: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201809.en.pdf 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?", dated October 5th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Our October house view meeting was mostly uneventful, ... : The backup in bond yields has so far proceeded in line with our expectations, and the BCA consensus is that they have not risen enough to pose a fundamental threat to equities. ... in contrast to the action in global equities: Single-day declines of 3-4% in headline equity indexes around the world gave investors a jolt, and revived the too-far/too-long talk about equity gains with a new intensity. We do not believe that the end of the U.S. equity bull market is at hand, ... : The components of our recession indicator do not suggest that a recession, or a bear market, is on the horizon. It appears that the fiscal stimulus package will keep the expansion going into 2020. ... but thinking through the factors that would lead us to downgrade equities will help put the ongoing data flow into context: In addition to the elements of our bear-market/recession indicator, we consider items that could pressure earnings, spur inflation, or indicate the presence of widespread exuberance. Feature BCA's strategists held their October View Meeting last Tuesday. The monthly meeting gathers all of the editorial staff together to determine the firm's internal consensus on the future direction of markets. The results are published in the form of our House View Matrix, and the discussion and debate of the rationales underpinning our views inform the content of the individual services' publications. The agenda this month focused squarely on interest rates, and consisted of two basic questions: 1) Why are Treasury yields rising, and what does it mean for other asset classes? 2) How worried should we be about the surge in Italian bond yields? Neither question provoked much disagreement. The room broadly agreed that Treasury yields have been rising for the welcome reason that robust U.S. growth calls for higher rates. The Fed has been doing its part at the short end via its gradual quarter-point-per-quarter rate-hike pace, and the bond market got into the act two weeks ago, breaking out to a new seven-year high on robust data releases and Chairman Powell's "long-way-from-neutral" remark (Chart 1). Our bond strategists expect that the Fed will walk back Powell's seemingly off-the-cuff comment, but its substance meshes easily with our assessment of a burgeoning economy that may well overheat in the face of supply constraints. Chart 1Breakout As we have recently argued, the implications for equities depend much more on the level of rates than on their direction. Until real rates begin to squeeze the economy, history suggests that their impact on stocks will be benign. All else equal, higher real rates are a by-product of a stronger economy, and increased economic strength has helped stocks more than the larger haircuts on future cash flows, mandated by a higher discount rate, have hurt them. Using real potential GDP as a proxy for the level at which higher rates would slow the economy, we estimate that the bull market won't meet its demise until the 10-year Treasury yield reaches 3.75-4%.1 Consensus was quickly reached on the Italian question. Although the situation bears close monitoring, BCA does not deem Italy to be a flash point for global financial markets. Our base case is that bond markets can easily handle the deficit back-and-forth between Rome and Brussels, and that the more worrisome outcome - Italy's exit from the Eurozone - is increasingly remote. A bond selloff could become self-perpetuating, but our Global Investment Strategy service believes that European policy makers would intervene if Italian sovereign yields broke above 4%.2 Some strategists expressed interest in downgrading the equity view to underweight. Although a considerable majority voted to maintain BCA's neutral stance, the final stages of the meeting were devoted to debating the merits of a more bearish take. That discussion led us to think about the factors that might encourage us to downgrade our view on equities. The rest of this week's report lays out those factors in the form of an equity-downgrade checklist to accompany the rates checklist we rolled out last month. Together, the two checklists will provide a real-time guide to the evolution of our key asset-allocation views. Our Base-Case Bull-Market Denouement While U.S. Investment Strategy has been slightly more constructive than the BCA consensus, we joined in the house-view downgrade of global equities in June without lament. We did so on the grounds that the latter stages of expansions and bull markets can be treacherous, and significant geopolitical uncertainties could make the current iteration especially so. Last week's swoon, and its remarkable intra-day equity volatility, revealed the wisdom of staying within sight of the shore. We nonetheless believe that it is too early to underweight equities and spread product. We remain constructive on the outlook because we expect the monetary policy cycle, the business cycle, and the credit cycle have yet to run their course. All three will continue to provide an equity tailwind for roughly another year, while allowing spread product to generate excess returns over Treasuries for another quarter or two. Our base case is that the cycles will turn once aggregate demand, ginned up by fiscal stimulus, runs into capacity constraints, stoking inflation pressures and compelling the Fed to impose more restrictive policy settings. Once tight policy is in place, the equity bull market will come to an end, followed by the expansion. The Equity Downgrade Checklist Recessions and bear markets regularly coincide (Chart 2), as multiple de-rating is typically not enough to effect a 20% decline on its own. Earnings have to contract as well, and they typically only do so within the context of a recession. The three components of our recession indicator3 - an inverted yield curve (Chart 3); year-over-year contraction in the index of leading economic indicators (Chart 4); and tight policy, defined as a target fed funds rate greater than the equilibrium fed funds rate (Chart 5) - comprise the first three items on our checklist (Table 1). We round out the recession section by watching for an uptick in the headline unemployment rate, which has led, or coincided with, every postwar recession (Chart 6). Chart 2Bear Markets And Recessions Tend To Coincide Chart 3The Yield Curve Has Called 8 Of The Last 7 Recessions... Chart 4... And So Have Leading Economic Indicators Chart 5Recessions Only Occur When Monetary Policy Is Tight Table 1Equity Downgrade Checklist Chart 6Beware An Uptick In The Unemployment Rate There is more to equity investing than trying to skirt bear markets, however. Our checklist therefore also focuses on elements that could induce corrections (declines of at least 10% that don't reach the 20% bear-market threshold). We focus on three broad categories of variables: those that could pressure earnings growth by undermining revenues, profit margins or both; those that promote uncomfortably high inflation; and those that indicate unsustainable investor over exuberance. We do not have any preconceptions about which, or how many, boxes would have be checked to inspire a downgrade; we are simply trying to obtain a holistic sense of the equity outlook. Earnings Headwinds Employee compensation constitutes the single largest component of corporate expenses, making wage increases a direct threat to profit margins. We view the employment cost index, including benefits, as offering the most comprehensive and accurate insight into companies' wage bill. It has been rising, albeit slowly, and the Fed would like to see it rise even more to ensure that the expansion's gains are shared more broadly across the income spectrum (Chart 7). It would seemingly be happy with wage growth in the mid-3% range, but anything beyond that, if not supported by an uptick in productivity, could lead to faster and/or larger rate hikes.4 Chart 7The Fed Wants Wages Higher, But Not Too Much Higher A stronger dollar makes American goods less competitive in the global marketplace. Extended advances confront U.S.-based multinationals with an unpalatable choice: cut prices to maintain share, or accept lesser share to maintain margins. Currency moves impact corporate profits with a lag, however, so the initial effects of the dollar's 7% advance since mid-February should only begin to surface in the third-quarter earnings season that kicked off on Friday. S&P 500 constituents have been dining out for a year on the dollar's 14% 2017 slide, and a march to 100 and beyond will give rise to a multi-quarter headwind (Chart 8). Chart 8From Tailwind To Headwind Interest accounts for a meaningful share of corporate expenses, especially given the post-crisis rise in corporate debt outstanding. Using BBB-rated bonds as a proxy for overall corporate indebtedness, we view 4.8 to 5%, a level corporations last contended with eight years (and a considerable amount of issuance) ago, as a range that might cause some indigestion (Chart 9). Chart 9Debt Service Costs Are Rising Rising wages squeeze profit margins, but they won't necessarily cut into profits if top-line growth is robust enough to overcome the cost increase. Wage gains have the potential to set off a virtuous circle in which spending increases enough to promote expanded payrolls and capital expenditures, leading to more spending, and so on. An elevated savings rate suggests that households have the capacity to help fuel the fire (Chart 10). If they decide to save that money instead, perhaps with an eye on the metastasizing pile of student debt, it could dampen the multiplier effect of higher wages. Chart 10Plenty Of Dry Powder For Consumption We do not have a hard-and-fast preconception for the point at which deterioration in the emerging markets would be felt in the U.S. Given the relatively closed U.S. economy - the oceans bordering it are big - we expect that the EM distress would have to be quite acute. Full-on decoupling is a chimera, however, even for the fairly insulated U.S., and weakened global demand will eventually make itself felt here. A major credit event or two in some of the larger EM economies would likely accelerate the process. Inflation Now that full employment has been achieved, and then some, the price-stability element of the Fed's mandate will come to the fore as the binding policy constraint. The Fed is still trying to nudge realized inflation and inflation expectations higher, to be sure, but its bias could turn on a dime. Force-feeding sizable fiscal stimulus to an economy already operating at capacity is a recipe for fueling upward inflation pressures. We expect that the Fed will eventually be obliged to hike rates at faster than a gradual pace to get the inflation genie back into the bottle. The Fed's 2% inflation target applies to the core PCE deflator, and growth above the top of the 2.5% range that's held for 20-plus years might make it uneasy if the inflation slope proves to be as slippery as we expect (Chart 11). Regarding inflation expectations, we are keeping a close eye on the long-maturity TIPS break-evens, the expected level of inflation implied by the difference in yields on nominal and inflation-protected Treasuries. Our bond strategists peg 2.3-2.5% as the break-even level consistent with the Fed's 2% inflation target, and expect that the Fed will turn more hawkish if break-evens breach the top end of the range (Chart 12). Inflation matters to the investing public, as well, and earnings multiples would surely contract if inflation fears break out among the general populace. Headline CPI growth that looked like it could persist in the mid-3s could easily spark a correction (Chart 13). Chart 11Mission Impossible(?): Limit Inflation ... Chart 12... While Nudging Inflation Expectations Higher Chart 13CPI Matters, Too Irrational Exuberance It is not easy to recognize over exuberance in real time, but it is a regular feature of cycle peaks. In a bull market that is already the longest in the postwar era, and an expansion that's on track to establish a postwar longevity record of its own, it would be surprising if things didn't ultimately get silly. We will have to rely on judgment to assess the overall climate of recklessness, but we can objectively track valuation levels relative to history. We are not troubled by a 15- or 16-handle forward P/E multiple (Chart 14). While other standard valuation metrics are elevated (Chart 15), they typically only compel our attention at +/- 2-standard-deviation extremes. Chart 14Nothing Irrational About P/E ... Chart 15... Or Other Valuation Metrics, On Balance Investment Implications There is a natural tension between market forecasts and investment strategy. The future is unknowable, and it is rarely prudent to position portfolios all-in based on necessarily uncertain forecasts. The divergence should be especially wide in the latter stages of a cycle, when a reversal could be right around the corner. Even though we are constructive on the economic and policy backdrops, we are positioned conservatively, equal-weighting equities, underweighting fixed income, and overweighting cash. We have created a checklist to track what it would take to make us turn bearish on equities because our inclination is to lean bullish, and try to capture what may be the last outsized returns for a while. Markets are never one-way, however, and we could flip back to overweight upon a 10-15% peak-to-trough decline if nothing altered our view about the bull market's remaining lifespan. We could also return to an equity overweight at current levels if Chinese policymakers were to pursue stimulus with the pedal-to-the-metal urgency that characterized their efforts in 2008 and 2016. We could even try to play a melt-up, with tight stops, if we thought one was about to take hold. We are keeping an open mind, as an investor always should. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the September 24, 2018 U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" available at usis.bcaresearch.com. 2 Please see the October 12, 2018 Global Investment Strategy Weekly Report, "Bond Bears Maul Goldilocks," available at gis.bcaresearch.com. 3 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Equity Bull Market Last?" available at usis.bcaresearch.com. 4 Fed Chair Jay Powell recently said that wage growth should approximately equal the sum of inflation and productivity gains. Given the 2% inflation target, and 1% trend productivity growth, the FOMC would likely be content with wage gains modestly above 3%.