Currencies
Highlights The euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. Liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle, and this brings three multi-year investment implications: Underweight German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio. Overweight the euro, specifically euro/dollar and euro/yuan. Overweight euro area retailers versus U.S. retailers. Feature Over the past 20 years or so, every major European country has at one time or another been given the dubious title 'the sick man of Europe'. Chart of the Week AAfter 2008, Everybody Recapitalised Their Banks... Chart of the Week B...Except Italy Remarkable as it sounds today, in the early 2000s the sick man was Germany - whose economy suffered recurring stalls; in 2007 it was Portugal; then in the aftermath of the Great Recession the sick man title went at different points in 2009 to the U.K. and to Spain, as both economies struggled to bounce back from the downturn. Thereafter, the title has variously gone to Ireland, Finland, France, and Italy. In most cases, the sick man title mistakes a cyclical problem for a structural problem. So when the cyclical weakness ends, the country shakes off the dubious title. Another common mistake is rushing to judgement on the wrong analysis. The best example of this is Japan. You may be familiar with Japan's so-called 'lost decades' or the term 'Japanification' used as a pejorative. The trouble is that the perception of such lost decades is outright wrong! The truth is that over the past two decades Japan's growth in real GDP per head, at 34%, is the best among major developed economies, easily outperforming Germany, the U.K. and the U.S. (Chart I-2). Chart I-2What Lost Decades? Japan Has Outperformed Everybody Else The point is that to level the playing field for countries' different demographic profiles, it is important to compare growth on a per head basis. Real growth per head is what determines improvement in wellbeing and living standards and the best resolution of indebtedness for society as a whole. High nominal growth via inflation may sound appealing to a highly indebted society, but it is over-simplistic. One person's debt is another person's asset, so inflation reduces the burden on half of society - the debtors - by robbing the other half - the creditors. Which isn't necessarily good for society as a whole. Can Italy Recover? This brings us to Europe's current 'sick man', Italy. Some people claim that Italy has underperformed through the full 18 years of the euro. Not true. Based on the all-important real GDP per head metric, Italy was performing more or less in line with the other major developed economies until the Great Recession (Chart I-3). Still, an underperformance that started at the Great Recession means it has lasted almost nine years. So can Italy really be a cyclical 'sick man' - or in this case, is something structural at work? In The Euro's 18th Birthday: Why Isn't Italy Partying?1 we suggested that the root cause of Italy's nine year problem is its still undercapitalised and dysfunctional banking system. This has paralysed an economy heavily dependent on small and medium sized enterprises (SMEs), and their access to bank financing. We can say this with conviction for two reasons. Can it really be just coincidence that Italy is the only major economy that has not recapitalised its banks after the 2008 crisis, and that its underperformance began at exactly the same moment (Chart of the Week)? And can it really be just coincidence that as soon as Spain substantially recapitalised its banks in 2013, the Spanish economy made a remarkable transformation from sick man to strapping health2 (Chart I-4)? To us, these are not coincidences. They pinpoint the root of Italy's problem and solution. Chart I-3Italy Did Not Underperform ##br##Until The Great Recession Chart I-4Spain Recovered Strongly As##br## Soon As Its Banks Were Recapitalised The good news is that Italy is progressing to a solution, albeit slowly. Last week's relatively trouble-free winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the ECB, Brussels and the Italian government are on the same page. A pragmatic solution let institutional investors suffer losses while protecting 'widows and orphans' retail investors with public money. In Italy, with many retail investors owning banks' senior bonds, this is the politically acceptable way to go. And at the current rate of resolution, we estimate that the further €50-75 billion of recapitalisation required can be finished within a year. If Italy can get through its next general election without a shock, it will be on the road to a long-term recovery. Euro Area: Don't Mistake A Cyclical Problem For A Structural Problem To reiterate, one of the biggest mistakes in economics and investment is to mistake a cyclical problem for a structural problem. This is especially true when two cyclical downturns come in quick succession. The resulting extended period of poor performance inevitably feels like something structural rather than something cyclical. Many commentators regard the poor performance of the euro area economy since 2008 as evidence of a structural malaise. But the bigger picture does not support this thesis. Through the 18 year lifetime of the monetary union, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-5). Chart I-5Since The Euro's Birth, The Euro Area And##br## U.S. Have Produced Identical Growth Within this bigger picture, the euro area has underperformed through multi-year periods encompassing around half of the 18 years. And it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance is really the impact of back to back recessions separated by an unusually short gap - with the second of the two recessions the direct result of policy errors specific to the euro area. First, the ECB resisted taking on its critical role as lender of last resort to solvent but illiquid sovereign borrowers, thereby enflaming a containable liquidity crisis into an almost uncontainable and catastrophic solvency crisis. Then, when the ECB ultimately relented, a protracted stress test of European banks forced lenders to shrink their assets, effectively paralysing an economy heavily dependent on bank finance. Still, the euro area does not have a monopoly when it comes to damaging policy errors and misanalysis. We tend to have short memories, but let's not forget former U.K. Finance Minister and Prime Minister Gordon Brown's claim that the boom-bust cycle had been abolished, justifying a much lighter touch regulation of the financial system through the early 2000s. Or Ben Bernanke's now infamous misanalysis of the U.S. housing market in 2005: "Well, I guess I don't buy the premise that U.S. house prices will come down substantially. It's a pretty unlikely possibility..." These observations are not meant to criticise, but just to illustrate that policymakers are not omniscient. They understand the economy and financial markets little more than we do. Furthermore, political constraints often limit their room for manoeuvre, forcing the policy errors. Policy Error Now More Likely Outside The Euro Area Looking ahead to the next few years, our sense is that the risk of policy error is now greater outside the euro area than inside. Specifically, the still uncertain trajectories of Brexit and of the Trump administration are likely to have their greatest disruptive impacts in the U.K. and U.S. respectively. Our broad thesis is that the euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. And liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle. Which brings three multi-year investment implications: Underweight euro area government bonds, specifically German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio (Chart I-6 and Chart I-7). Overweight the euro, specifically euro/dollar and euro/yuan. For equities, the translation to the headline euro area index, the Eurostoxx50 is somewhat complicated by its dominant sector skew (overweight banks, underweight technology) which tends to drive relative performance. Instead, we find that in recent years the relative performance of the more domestic-focussed retailers has closely tracked relative economic performance (Chart I-8). Hence, overweight euro area retailers versus U.S. retailers. Chart I-6Relative Bond ##br##Yields... Chart I-7...Must Follow Relative##br## Economic Performance Chart I-8Retailers Relative Performance Tracks##br## Relative Economic Performance Please note there will be no report next week. Our next report will come out on July 20. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on June 1, 2017 and available at eis.bcaresearch.com 2 Spain's real GDP per head has grown by over 12% since its trough in 2013. Fractal Trading Model* Long nickel / short palladium has achieved its 10% profit target, and is now closed, leaving four open positions. There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Recommended Allocation Risk assets have continued to outperform, despite soft inflation data and falling interest rates. Either inflation will pick up again, amid decent growth, and the Fed (and, to a degree, other central banks) will tighten, or the Fed will capitulate and stay on hold. Either scenario should be good for risk assets. No indicator signals a recession on the horizon, and so we continue to expect equities to outperform bonds over the next 12 months. Within equities, we favor DM over EM; we maintain a pro-cyclical sector tilt, but rotate out of Tech into Financials, which are cheaper and should benefit from steeper yield curves. In fixed income, we prefer credit to government bonds, but trim our overweight in investment grade credit as spreads are unlikely to contract further. We are overweight TIPS and Japanese inflation-linked bonds. Feature Overview How To Square Lower Rates And Rising Equities One of the basic principles of BCA's Global Asset Allocation service is that it is highly unusual for equities to underperform bonds for any extended period except in the run-up to, and during, recessions (Chart 1). After the recent decline in long-term interest rates and softness in inflation, we find investors worldwide becoming increasingly nervous about the outlook. We see nothing in the data, however, to indicate a recession in the coming 12 months. Of the three historically most reliable recession indicators - PMIs, credit spreads, and the yield curve (Chart 2) - only the last raises some concerns, but it is still far from inverting, which is the requirement for a recession signal. None of the formal recession models is flashing a warning signal either (Chart 3). Chart 1Stocks Outperform Except Ahead Of Recession Chart 2Usual Recession Signals Still Absent Chart 3Recession Risk Models Not Rising Either Nonetheless, market action in recent months has been unusual. Bond yields have fallen (with the 10-year U.S. Treasury yield slipping to 2.2% from 2.6%), and the dollar has weakened, but risk assets have continued to perform well, with global equities giving a total return of 13% year to date and 4% in Q2. Can this desynchronization continue? We see three possible scenarios:1 Chart 4Market Expects Fed To Be Dovish Reflation returns. The Fed proves to be right that the recent weak inflation data is temporary. Inflation picks up and the Fed raises rates more quickly than the market is currently pricing in (which is only 25 bps over the next 12 months, Chart 4). Initially, the rebound in inflation might be a shock for risk assets but, as long as the Fed is tightening because it is confident about growth and unconcerned about global risk, over 12 months risk assets such as equities should continue to outperform. The Fed capitulates. Inflation fails to rebound and the Fed tightens only in line with what the market is currently pricing in. This could be good for risk assets, as long as the soft inflation is not accompanied by disappointing data on growth. The U.S. dollar would probably weaken further, which should be positive for EM assets and commodities. A policy mistake. The Fed pushes stubbornly ahead with tightening even though inflation fails to rebound. Bond yields fall and the yield curve moves closer to inverting. This would be negative for risk assets, which would start to price in the risk of recession. We think the first scenario is the most likely. Leading indicators of employment suggest the recent sluggish wage growth should prove temporary (Chart 5). The softness in U.S. PCE inflation probably reflects mostly the weak economic growth last year and the recent fall in commodity prices (as well as special factors in telecoms, healthcare and autos). Even if reflation pushes the Fed to tighten more quickly - followed by central banks in the euro area, U.K, and Canada, which have also sounded more hawkish recently - this should not fundamentally undermine the case for risk assets, given how easy monetary policy remains everywhere (Chart 6). It would represent merely a step towards "normalization". Chart 5Sluggish Wage Growth Should Be Temporary Chart 6Real Rates Still Negative Everywhere While scenario (2) would also probably be generally positive for risk assets, the correct portfolio allocation would be different. Under scenario (1) - our central view - the dollar would appreciate, causing commodities and EM assets to underperform, higher beta markets (such as the euro area and Japan) and cyclical sectors would perform the best, and in bond markets investors should be underweight duration and overweight TIPS. Scenario (2) would suggest a less aggressive positioning in equities, with income-generating assets outperforming as bond yields stay low at around current levels. Scenario (3), which we see only as a tail risk, would point to an outright defensive stance. What should investors watch for over the coming months? Besides the trends in inflation and wages discussed above, we would be concerned to see any slippage in global growth expectations, which have so far continued to rise despite the softness in inflation and wages (Chart 7). The most likely cause of this would be a Chinese slowdown, though recent comments by Premier Li Keqiang ("we continue to implement a proactive fiscal policy and prudent monetary policy....[but] will not resort to massive stimulative measures") seem to confirm our view that Chinese growth may slow a little further, but that the authorities will not allow it to collapse ahead of the Party Congress in the fall. As potential upside catalysts for risk assets we see: a rebound in crude oil prices (driven by a drawdown in inventories over coming months as the OPEC production cuts reduce supply, Chart 8), progress on a U.S. tax cut (which BCA's Geopolitical Strategy still expects to come into effect from early 2018), and further surprises in earnings growth (where analysts continue to revise up their forecasts, Chart 9). Chart 7No Signs Of Global Growth Slipping Chart 8Oil Inventories To Draw Down Chart 9Earnings Continue To Be Revised Up Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Why Haven't Inflation And Wages Picked Up? Chart 10Just A Temporary Phenomenon? Eight years into an expansion, U.S. inflation remains stubbornly below 2% on every measure and has even slowed in recent months (Chart 10, panel 1). And, despite headline unemployment of only 4.3% (below the Fed's estimate of 4.6% for the Nairu), wage growth also remains sluggish (panel 3). The Fed's view is that inflation has been pulled down by special factors: weak auto sales, the introduction of unlimited cell phone data packages (which lower hedonically-adjusted prices), and drugs companies which raised prices before last year's U.S. presidential election (panel 2). We agree that these factors are likely to be temporary. But the recent weak wage growth is more puzzling. Wages have trended up since 2012, suggesting that the Phillips Curve is not dead. But the relationship seems to have weakened. With U6 unemployment (which includes marginally attached workers and those working part-time who would like full-time jobs) currently at only 8.4%, one would have expected wage growth to be 1 ppt higher than it is (panel 4). Changes in the structure of the workforce may partly explain this (the growing proportion of low-wage service jobs, the "gig economy"). Last year's weak corporate profits may also be a factor. But, with the labor market clearly very tight, we expect wages - and therefore core inflation - to pick up again over the next 12 months. What To Do When VIX Is So Low? After two brief spikes earlier in the year, VIX has declined to 11.4, closer to the historical low of 9.3 reached in 1993, than the historical average of 19.5. In fact, asset price volatilities have been low across the board in fixed income, currencies and commodities, even though the latter two are not at the same extreme low levels as equities and fixed income (Chart 11). However, the VIX futures curve is still in steep contango, which means that getting the timing wrong would make it very costly to go long the volatility index. In addition, correlation among the index members of the S&P 500 is very low, and so are cross-market equity correlations. We do not forecast a recession until 2019, so a sharp reversal in VIX is unlikely, but brief spikes are possible, implying possible corrections in S&P 500 given the inverse correlation between the two. As such, we recommend four strategies for investors who are concerned that markets are too complacent: Focus on security selection, and rotate into cheaper sectors from expensive ones without altering the pro-cyclical bias. Our preferred way is to buy the much cheaper Financials by selling the more expensive Tech; Allocate a portion of funds to the minimum volatility style as it has been relatively oversold; Raise cash and buy a call spread on the S&P 500; Buy longer-dated VIX futures and sell shorter-dated futures to mitigate the rolling cost. Chart 11Are Investors Too Complacent? Chart 12Overweight To Neutral Have Technology Stock Run Too Far? Technology stocks have outperformed the broad market by 33% since April 2013 and investors are increasingly skeptical about whether the run-up can continue. In this Quarterly, we cut our weighting in the Tech sector from Overweight, but we believe it deserves no lower than a Neutral weighting for the following reasons: Sales & Earnings: New order growth is improving alongside rising consumer spending on technology (Chart 12, panel 2). Sales are growing at 5% YoY and this is likely to continue. Pricing power has also recovered over the past year. These factors should support margins and earnings growth. Valuations: Investors are worried about valuation. However, the recent rally has not led to an expansion of relative forward P/E, which is below the historical average (panel 4). Sector relative performance over the past four years has moved in line with its superior return on equity. Breadth: Improving breadth suggests that relative outperformance should be sustainable. An increasing number of firms are participating in the rally, as seen by the improving advances/declines ratio (panel 3). However, we also have some concerns. For example, a handful of large-cap technology firms have generated the bulk of the stock price performance. However, these firms currently trade at 23x.2 earnings compared to 60x.3 for the top firms at the peak of the TMT bubble in 2000. Additionally, the five largest stocks in the sector comprise only 13% of the index, compared to 16% at the peak of the 2000 bubble. Our recommendation, then, is that investors should hold this sector in line with benchmark. Are Canadian Banks At Risk Due To The Housing Bubble? Chart 13Canadian Housing Puzzle The recent problems at Home Capital Group have drawn investors' attention to the Canadian housing market. Home Capital's shares fell by 70% in April after regulators accused the mortgage lender of being slow to disclose fraud among its brokers. However, the issue is unlikely to have wider consequences: the event took place two years ago and had no impact on the lender's assets. Home Capital lends only to individuals with reliable collateral, and accounts for only 1% of total mortgage loans. We don't see imminent risks to the housing and banking sectors, since the economy is recovering and monetary policy remains loose. Vancouver and Toronto home prices have surged for almost a decade (Chart 13, panel 1). After Vancouver introduced a 15% foreign buyer tax in July 2016, house prices initially pulled back but quickly recovered. A similar tax in Ontario this April is also likely to have limited impact. Cautious macro-prudential rules should ensure banks' health: mortgage insurance is required for down-payments under 20%, and the gross debt service ratio (total housing costs over household income) cannot exceed 32%. However, the rise in house prices has caused household debt to run up (Chart 13, panel 2). Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, hinted in a speech in June that the central bank may soon raise rates. Tighter monetary policy could hurt mortgage borrowers who have enjoyed low interest payments for years (Chart 13, panel 3). Over the longer-term, therefore, we are concerned about the level of household debt, and recommend a cautious stance toward Canadian bank stocks. Global Economy Overview: Goldilocks continues, with global growth prospects still good (PMIs in developed economies generally remain around 55 - see Chart 14 panel 2 and Chart 15 panel 1), but inflation surprising on the downside in recent months. The wild card is China, where growth has slowed since Q1, when GDP reached 6.9%, and it is unclear whether the authorities will ease fiscal and monetary tightening to cushion the slowdown. Chart 14Growth Prospects Generally Remain Good Chart 15But Inflation Expectations Have Fallen U.S.: Growth has been weaker than the over-heated consensus expected, pushing down the Citigroup Economic Surprise Indexes (CESI) sharply (Chart 14, panel 1). However, prospects remain positive for the next 12 months: the Manufacturing ISM is at 54.9, retail sales are growing at 3.8% YoY, and capex has begun to reaccelerate (Chart 14, panel 5). The Fed's Nowcasts point to Q2 GDP growth at 1.9%-2.7% QoQ annualized. With expections now lowered, the CESI is likely to bottom around here. Euro Area: Growth has been stronger than in the U.S, with the PMI continuing to accelerate to 57.3. However, this is largely due to the euro area's strong cyclicality and exposure to global growth. Domestic momentum remains weak in most countries, with region-wide wage growth only 1.4% YoY. European PMIs are likely to roll over in line with the U.S. ISM. But GDP growth for the year is not likely to fall much from the 1.9% achieved in Q1. Japan remains a dual-paced economy, with international sectors doing well (exports rose by 14.9% YoY in May and industrial production by 5.7%) but domestic sectors stagnating, as wage growth remains sluggish (up just 0.5% YoY). Bank of Japan policy will remain ultra-easy, but there is scant sign of fiscal stimulus or structural reform. Emerging Markets: China is showing clear signs of slowdown, with the Caixin Manufacturing PMI falling below 50 (Chart 15, panel 3). The PBoC has tightened monetary policy, causing corporate bond yields to rise by 100 bps since the start of the year and the yield curve to invert. However, with the 19th Communist Party Conference scheduled for the fall, the authorities will prioritize stability: there are signs they are increasing fiscal spending. Elsewhere, many emerging markets are characterized by sluggish growth but falling inflation, which may allow central banks to cut rates. Interest rates: Inflation has softened recently, with U.S. core PCE inflation slowing to 1.4% and euro zone core CPI to 1.1%. We agree with the Fed that the recent weak inflation was caused by temporary factors and, with little slack in the labor market, core PCE will rise to 2% by next year, causing the Fed to hike in line with its dots. In the euro zone, however, the output gap remains around -2% of GDP and countries such as Italy could not bear tightening, so the ECB will taper only gradually next year and not raise rates soon. Chart 16Powered by Earnings and Margin Improvement! Global Equities In Q2 2017 the price gain in global equities was driven entirely by earnings growth, as forward earnings grew by 3.5% while the forward PE multiple barely changed. This is distinctively different from the equity rally in 2016 when multiple expansion dominated earnings growth (Chart 16). The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also come in very strong, with 90% of sectors registering positive earnings growth. Margins improved in both DM and EM. Equity valuation is not cheap by historical standards but, as an asset class, equities are still attractively valued compared to bonds given how low global bond yields are. We remain overweight equities versus bonds even though we are a little concerned about the extremely low volatility in all asset classes (see "What Our Clients Are Asking" on page 8). Within equities, we maintain our call to favor DM versus EM despite the 7% EM outperformance year-to-date, which was supported by attractive valuations and the weak U.S. dollar. BCA's house view is that the USD will strengthen versus EM currencies over the coming 12 months. Within EM, we have been more positive on China and remain so on a 6-9 month horizon, in spite of China's 6.7% outperformance versus EM. Our upgrade of euro area equities to overweight at the expense of the U.S. in our last Quarterly Portfolio Outlook proved to be timely as the euro area outperformed the U.S. by 641 bps in Q2. We continue to like Japan on a currency hedged basis (see next page). Sector-wise, we maintain a pro-cyclical tilt. However, we are taking profit on our overweight in Technology (downgrade to neutral) and upgrading Financials to overweight from neutral. Japanese Equities: Maintain Overweight, With Yen Hedge We upgraded Japanese equities to overweight in June 2016 (please see our Quarterly Report, dated June 30, 2016 and our Special Report, dated June 8, 2016) on a currency hedged basis. These positions have worked very well as the yen is down by 10% and MSCI Japan has gained 32% in yen term, outperforming the global benchmark by 12% in local currency terms, but in line with benchmark in USD (Chart 17). Going forward, we recommend clients continue to overweight Japanese equities in a global portfolio and hedge the JPY exposure. Reasons: First, since December 2012 when Abenomics started, MSCI Japanese equities have gained 82% in yen terms, but earnings have risen by much more, with a 180% increase. Valuation multiples have contracted, in stark contrast to other major equity markets where multiple expansion has led to stretched valuations. Second, divergent monetary policy between the BOJ and the Fed will put more downside pressure on the JPY. More importantly, weak fundamentals, as evidenced by falling inflation and a slowing in GDP growth, are likely to push the BOJ to resort to more extraordinary policy measures, such as debt monetization, which would further weaken the JPY, boosting exports and therefore the export sector dominated Japanese equity market. Note that our quant model is still underweight Japan, but has become slightly less so compared to six months ago. We have overridden the model because 1) the model is unhedged in USD terms and, more importantly, 2) the model cannot capture potential policy action such as debt monetization. Chart 17Japanese Equities: Remain Overweight Chart 18Financials Vs Tech: Trading Places Sector Allocation: Upgrade Financials to Overweight by Downgrading Tech to Neutral. We have been overweight Technology since July 2016 (please see our Monthly Update, July 29, 2016) and the sector has outperformed the global benchmark by 11.8%, of which 9% came this year. In line with our general concern on asset valuations, we are taking profit on the Tech overweight and use the proceeds to fund an overweight in the much cheaper Financials sector. As shown in Chart 18, the relative total return performance of Financials vs. Technology is back to extreme levels (panel 1), while the relative valuation of Financials measured by price to book has reached an extremely cheap level (panel 2). Also, Financial shares offer a good yield pick-up over Tech even though this advantage is in line with the historical average (panel 3). BCA's house view calls for higher interest rates and steeper yield curves over the next 9-12 months. Financial earnings benefit from a steepening yield curve. If history is any guide, we should see more aggressive analysts' earnings revisions going forward in favor of Financials (panel 4). Overall, our sector positioning retains its tilt towards cyclicals vs. defensives. (Please see Recommended Allocation table on page 1), in line with the tilt from our quant model. Within the cyclical sectors, however, we have overridden the model on Financials and Tech since the momentum factor is a major driver in the model and we judge that momentum has probably run too far. Chart 19MSCI ACW: Factor Relative Performance Smart Beta Update: In Q2, an equal-weighted multi-factor portfolio outperformed the global benchmark (Chart 19, top panel). Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - quality and momentum factors continued the Q1 trend of outperformance, while value continued to underperform. It's worth noting that the underperformance of minimum volatility stabilized in the last two months of the quarter, indicating that the extremely low market vol has caught investor attention and some investors have started to seek protection by moving into the low vol space, albeit gradually. Value has continued to underperform growth, and small caps to underperform large caps. We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying themes given the historically close correlation between styles and cyclicals versus defensives (bottom two panels). As show in Table 1, however, even though value has underperformed growth across the globe, small caps in Japan and the euro area have consistently outperformed large caps year-to-date, the opposite to that in the U.S., in line with the higher beta nature of these two markets. Table 1Divergence In Style Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q2 to below fair value levels in response to weaker "hard data" (Chart 20, top panel). But weakness in Q1 U.S. GDP was concentrated in consumer spending and inventories, both of which are likely to strengthen in the months ahead. In addition, after the June rate hike, we expect the Fed to deliver another rate hike by year end, while the market is pricing in only 14 bps of rate rise. Maintain overweight TIPS vs. Treasuries. As the nominal 10-year yield fell, so did 10-year TIPS breakeven inflation. In terms of relative valuation, now TIPS is fairly valued vs. the nominal bonds (panel 2). However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target later this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Overweight Inflation-linked JGBs (JGBi) vs. Nominal JGBs. Inflation in Japan has been falling despite strong GDP growth. However, the labor market has not been this tight since the mid-1990s, with the unemployment rate at 3.1% and jobs-to-applicants ratio at 1.49, both post-1995 extremes (Chart 21, panel 2). BCA Foreign Exchange Strategy service believes that wage pressures, in addition to the inflationary effect of a weakening yen, could lead inflation higher. Accordingly, inflation-linked JGBs offer good value relative to nominal JGBs (Chart 21, panel 1). Chart 20Inflationary Pressures Are Building Chart 21Overweight JGBi Vs JGB Corporate Bonds Given our expectations that global growth will remain robust over the coming 12 months, pushing the U.S. 10-year Treasury yield above 3%, we continue to favor credit over government bonds. However, U.S. corporate health has deteriorated further in the past two quarters (Chart 22) and so, when the next recession comes, returns from corporate credit may be particularly bad. We cut our double overweight in investment grade debt to single overweight. The spread over Treasuries of U.S. IG credit has fallen to around 100 bps. Given high U.S. corporate leverage currently, it is unlikely that the spread will tighten any further to reach previous lows (Chart 23), so investors will benefit only from the carry. Moreover, the ECB is likely to reduce its bond buying from January 2018 and, though it is unclear whether it will taper corporate as well as sovereign purchases, this represents a potential headwind for European credit. Remain overweight high yield debt. U.S. junk bonds have been remarkably resilient in the face of falling oil prices and the subsequent blowout in energy bond spreads. The default-adjusted spread is just over 200 bps (Chart 24), based on Moody's default assumption of 2.7% over the next 12 months and a recovery rate of 47%. Historically, a spread of this size has produced an excess return over the following year 74% of the time, for an average of 84 bps. Chart 22U.S. Corporate Health Deteriorating Chart 23IG Spreads Unlikely To Tighten Further Chart 24Junk Spreads Give Sufficient Reward Commodities Chart 25Mixed Feelings Towards Commodities Secular Perspective: Bearish: We continue to hold a negative secular outlook for commodities (Chart 25). A gradual shift towards a service-led economy in China, combined with sluggish global growth, will prevent demand from rising further. This lack of demand, together with record high inventory levels for major commodities, keep us from turning bullish. Cyclical Perspective: Neutral We are positive on oil because we believe that inventories will continue to draw. We are negative on base metals due to weak demand and excess supply. We are somewhat bullish on precious metals based on the political uncertainties ahead. Energy: Bullish OPECextended its production cuts for another nine months, carrying the cuts through to Q1, when the oil price is typically seasonally weak. We expect demand growth will increasingly outpace production growth in 2017, producing inventory drawdowns. The current weakness in the crude price is largely due to investors' concerns over shale production. However, the OPEC cut of 1.2 MMb/d, supplemented by an additional 200,000 - 300,000 b/d of voluntary restrictions on non-OPEC oil, are enough to offset any spurt in shale production. Base metals: Bearish China is slowly tightening monetary policy and, following the 19th Communist Party Congress later this year, reflationary stimulus will probably continue to wind down. We have seen a cooling in the Chinese property market along with a slowdown in the manufacturing sector. The Caixin manufacturing PMI, a key indicator for metals demand, fell below 50 in May for the first time in 11 months. At the same time, inventories for copper and iron ore have risen. Precious metals: Long-term Bullish Inflation has not picked up as we expected, which may prevent the gold price from rising further in 2017. However, we expect inflation to move higher going into 2018. As a safe haven, gold is also a good hedge against geopolitical risks. We believe that the political risks in 2018 are underestimated, especially the Italian general election (probably in March or April). Currencies Chart 26Fed Will Support The Dollar In 2017, the U.S. dollar (Chart 26) has weakened by 5% on a trade-weighted basis. However, we believe that the soft patch in inflation and wage data that caused this weakness is temporary and that underlying economic momentum remains strong. Following its rate hike in June, the Fed kept its forecast for core PCE in 2018 and 2019 at 2%. As inflation and wage pressures return, market expectations will converge with the Fed's forecast. The subsequent improvement in relative interest rates will support the dollar. Euro: The euro is up by 8% versus the dollar so far this year. The ECB is likely to continue to set policy for the weakest members of the euro zone, in the absence of a major pickup in inflation. While economic activity has improved, inflation has recently fallen back again, along with the oil price. The ECB is particularly sensitive to political uncertainty surrounding the upcoming Italian elections and the fragility of the Italian banking system. This suggests that the ECB will only gradually taper its asset purchases starting early next year, but will not move to raise rates until at least mid-2019. This is likely to cause the euro to weaken over the coming months. Yen: The yen has strengthened by 4% versus the dollar year to date. With core core inflation in Japan struggling to stay above 0%, we think it highly likely that the BOJ will continue its yield curve control policy. If, as we expect, U.S. long-term interest rate trend up in the coming months, relative rates will put downward pressure on the yen. Our FX strategists expect the USD/JPY at 125 within 12 months. EM Currencies: With Chinese growth likely to remain questionable over the coming months, emerging market currencies will lack their biggest tailwind. Terms of trade will continue to turn negative as commodity prices weaken. EM monetary authorities will mostly be easing policy in order to support growth. With rates kept low, relative monetary policy is likely to will force EM currencies, especially those for commodity exporters, to depreciate from current levels. Alternatives Chart 27Attractive Risk-Return Profile Return Enhancers: Favor private equity vs. hedge funds In 2016, private equity returned 9%, whereas hedge funds managed only a 3% return (Chart 27). Strong performance led to private equity funds raising $378 bn last year, the highest level of capital secured since the Global Financial Crisis. By contrast, hedge funds have underperformed global equities and private equity since the financial crisis of 2008-09. However, investors have become increasingly concerned with valuation levels in private markets. Our recommendation is that investors should continue to overweight private equity vs hedge funds, since we do not see a recession as likely over the next 12 months. Within the hedge fund space, we would recommend overweighting event-driven funds over the cycle, and macro funds heading into a recession (please see our Special Report, dated June 16, 2017). Inflation Hedges: Favor direct real estate vs. commodity futures In 2016, direct real estate returned 9%, whereas commodity futures achieved 12%. Given the structural nature of this recommendation, investors need to look past recent short-term moves in commodity prices. Low interest rates will keep borrowing cheap, making the spread between real estate and fixed income yields continue to be attractive. Moreover, with 48% of institutional investors currently below their target allocation for real estate, there is a lot of potential for further capital allocations to the asset class. With regards to the commodity complex, the long-term transition of China to a services-based economy will lead to a structural decline in commodity demand. Investors should continue to overweight direct real estate vs commodity futures on a 3-5 year target horizon. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2016, farmland and timberland returned 9% and 3% respectively, whereas structured products returned 2%. Farmland and timberland will continue to benefit from favorable global demographic trends, as a growing population and improving prosperity in the developing world increase food consumption. However, increased volatility in lumber and agriculture prices have made investors concerned about cash flows. With regards to structured products, increasing rates and deteriorating credit quality in the auto loan market will slow credit origination. Given that the Fed will start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. Risks To Our View We explained the two alternative scenarios to our main view in the Overview section of this Quarterly. There are three other specific areas where our views differ notably from the consensus: Strong dollar. Our view is predicated on the Fed tightening policy more than the market currently expects, and the ECB less. Interest rate differentials (Chart 28) certainly point to a stronger USD, and speculative positions have reversed from being very dollar-long at the start of the year. But the euro momentum could continue for a while, especially given mixed messages from Mario Draghi, for example when he said in late June that "the threat of deflation is gone and reflationary forces are at play." Crude oil back at $55. Our Energy strategists believe that the oil price is currently being driven by supply, not demand. They argue that OPEC production cuts will hold and cause inventories to draw down rapidly over the coming six months. However, speculative positioning in oil has shifted from very long to significantly short since the start of the year. The risk is that U.S. oil production continues to accelerate (Chart 29), as fracking technology improves and availability of capital for oil producers remains easy. Negative on EM. Our 12-month EM view is predicated on a stronger dollar, higher U.S. interest rates, slowing Chinese growth, and falling commodity prices. We could be wrong about these drivers. Falling inflation in emerging markets such as Brazil (Chart 30) could allow central banks to cut rates aggressively, which might temporarily boost growth. Chart 28Rate Differentials Suggest Strong Dollar Chart 29Oil Bears Point To U.S. Output Chart 30Sharp Fall In Brazilian Inflation 1 Our U.S. Bond Strategists explain the detailed thinking behind these three scenarios in their Weekly Report "Three Scenarios for Treasury Yields In 2017," dated June 20, 2017, available at usbs.bcaresearch.com 2 Market-cap weighted average of Apple, Alphabet, Microsoft, Amazon and Facebook. 3 Market-cap weighted average of Microsoft, Cisco Systems, Intel, Oracle and Lucent. Recommended Asset Allocation
Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades