Defensive/Risk
Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Figure I-2People Dislike Negative Skew For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Upbeat economic reports for December set the stage for a solid 2018. The FOMC minutes acknowledged the flatter curve and only a minority of members discounted the signal from the curve. A majority thought that a tighter labor market would lead to higher inflation. The Citi Economic Surprise Index is peaking, but risk assets should hold up as the Index rolls over. Feature The first week of 2018 brought more good news for risk assets. U.S. stocks beat bonds, oil prices rose, and credit spreads narrowed amid a solid set of economic data. Several high-profile U.S. companies announced share buybacks, and/or one-time bonuses or wage increases linked to the tax cut plan passed by Congress at the end of 2017. Moreover, there were hints of further economic stimulus as lawmakers from both sides of the aisle discussed relaxing the sequester rules that would lift federal spending this year. Markets shrugged off a fresh round of saber rattling between the U.S. and North Korea. Gold prices nudged higher and the U.S. dollar fell despite the upbeat economic news. December's reports on manufacturing and service sector ISM, vehicle sales and the labor market, along with November's numbers on construction spending, trade and factory orders, all lifted estimates for Q4 GDP and boosted the prospects for corporate earnings in Q4 2017 and beyond. Chart 1 shows that the elevated ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 2 indicates that IP, a proxy for S&P 500 sales, is poised to advance in 2018 and provide a lift to corporate profits. We will preview the S&P 500's Q4 2017 earnings reports in next week's U.S. Investment Strategy. Chart 1Favorable Macro Backdrop For Earnings And Sales Chart 2ISM Components Suggest IP Poised To Accelerate The Atlanta Fed GDP Now estimate stood at 2.7% on January 5, while the New York Fed's Nowcast for Q4 GDP was a healthy 4% (Chart 3). Both soundings are well above the FOMC's assessment of the economy's long-term potential growth rate (1.8%) and puts GDP growth in 2017 above the Fed's forecast. The implication is that the output gap pushed deeper into positive territory as 2017 ended, setting the stage for higher inflation in 2018. The December 2017 jobs report, released last Friday, January 5, does not change BCA's outlook for the U.S. economy or the Fed. The U.S. economy added a lower than expected 148,000 new jobs in December, which left the unemployment rate unchanged at 4.1%. Despite the softer than anticipated data, the 3-month average of payrolls growth is still a very healthy 204,000. The monthly increase in wages quickened to 0.3% m/m in December, up from 0.1% m/m last month. However, annual wage inflation remains modest at just 2.5% (Chart 4). Chart 3U.S. Economic Growth Well##BR##Ahead Of Potential In Q4 Chart 4Labor Market Still Tightening Despite##BR##Soft December Report The indications for Q4 GDP growth are solid. Aggregate hours worked rose 2.5% at an annualized rate in Q4 2017. Assuming modest growth in productivity, the payrolls data are consistent with over 3% GDP growth in Q4. There is nothing in the December payroll data to suggest that the underlying trajectory in the U.S. economy has changed. The economy continues to grow above trend. Wage gains are modest at the moment, but should accelerate as the labor market keeps tightening with above-trend GDP growth. This upbeat economic outlook is also supported the December 2017 non-manufacturing ISM survey, also released last Friday. While the overall index fell from 57.4 to 55.9, it is still consistent with solid GDP growth. Moreover, the employment index rose from 55.3 to 56.3, which signals firm job gains, and the prices paid index held steady at a fairly elevated level of 60.8. Bottom Line: It's been solid start to 2018 and it's steady as she goes for the U.S. economy and the Fed. FOMC Minutes: A Rubric BCA's U.S. Bond Strategy service expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 51 bps at the end of 2017 through mid-year 2018, and then flatten into year-end (Chart 5). Which asset classes would benefit if our curve call is accurate? BCA's "The Bucket List"1 explains our view of the curve in 2018 and details the past performance of various U.S. assets in differing yield curve environments. Chart 5A Flat Yield Curve Is OK For Most Risk Assets BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive this year; earnings growth is higher 75% of the time when the curve is flat. The yield curve's slope was a focus of debate at the FOMC's December 12-13, 2017 meeting. Participants cited several reasons for the flat curve2: recent increases in the target range for the federal funds rate; reductions in investors' estimates of the longer-run, neutral real interest rate; lower longer-term inflation expectations; lower term premiums Fed economists recently updated their quantitative assessments of the FOMC's minutes. The note provides a guide (Table 1 in the Fed paper3 and Tables 1 and 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on the yield curve and inflation. Table 1FOMC Assessment Of The Yield Curve Table 2FOMC Assessment Of Inflation In short, the FOMC acknowledged the flatter curve and only a minority of members discounted the signal from the curve. Moreover, a majority thought that a tighter labor market would lead to higher inflation. Only one participant held the view that secular trends were muting inflation. Bottom Line: BCA expects the Fed to deliver 3 to 4 rate hikes in 2018, which is still not fully priced in by the market. Investors should maintain below-benchmark duration in fixed income portfolios. Asset allocators should remain overweight stocks versus bonds. Growth is strong and the yield curve is not inverted yet. Therefore, it is still early to de-risk portfolios. Is Economic Surprise Peaking? The Citigroup (Citi) Economic Surprise Index is elevated relative to its recent history, but it may have further to run. Economic prospects were cheery following the 2016 presidential election and the economic data exceeded those lofty projections, aided by a warmer than usual winter. However, the temperate conditions borrowed activity from the spring, which was cooler and wetter than normal, and the combination of lofty expectations and seasonal distortions sent the Citi Economic Surprise Index spiraling lower through mid-year 2017. Since its bottom in June 2017 at -78.6%, the index climbed for 135 days before its peak in late December 2017 (Chart 6, panel 1). On average since 2010, the Citi Index moved from trough-to-peak in 96 days, which means the recent run-up was much longer than usual. However, that phenomenon may have been due to the raised economic expectations and variable weather patterns at the start of 2017. Chart 6Economic Surprise Index Has Surged, But Expectations Remain Muted At 80.7%, the Index has been above zero for 68 days (Chart 6, panel 1). It typically takes 46 days for it to climb from zero to its zenith. Table 3 shows the performance of financial markets and other assets after the Index moves from zero to the peak. The most recent episode (October through December 2017) matched historical averages across most asset classes, although the underperformance of small caps versus large ran counter to the past as the Surprise Index climbed from zero. Table 3Risk Assets Perform Well As Surprise Index Climbs Since 2010, the Index has stayed above 40 for an average of 51 days (Chart 6, panel 1). The Index has been over 40 since November 16, 2017, or 35 days. This suggests that it can remain elevated for another month or so before it again moves lower. However, the Index is mean reverting and investors wonder what will happen to risk assets after economic surprise rolls over. Table 4 and Chart 7 shows the performance of key financial markets and commodities when the Citi Index returned to zero from 40-plus. There have been six such intervals since 2010. On average, gold and oil perform well as the surprise index dips to zero. Stocks and credit outperform Treasuries during these episodes, and small caps beat large caps. Rising economic surprise (Table 3) is a more favorable environment for stocks, credit and oil than when the surprise index is rolling over. However, the performance of gold and small caps is better after the Citi Surprise Index peaks (Table 4). Table 4Risk Assets Hold Up When Citi Surprise Index Rolls Over Chart 7U.S. Assets As Economic Surprise Rolls Over Nonetheless, muted economic expectations will limit the downside in the Index in the coming months. Panel 3 of Chart 6 shows that the outlook for both hard and soft economic data remained muted through the end of November 2017, especially when compared with the significant improvement in economic prospects in late 2016 and early 2017. Bottom Line: Risk assets outperformed as the Citi Economic Surprise Index climbed in the second half of 2017. The Index can stay near recent peaks for several more months thanks to subdued economic forecasts, but it will roll over eventually. However, the elevated level of the Index suggests that there are near-term risks for equities and credit because a lot of good economic news is already priced in. Still, we recommend that investors ride out the volatility given our view that stocks will outperform bonds in the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Bucket List", published December 18, 2017. Available at usis.bcaresearch.com. 2 https://www.federalreserve.gov/monetarypolicy/fomcminutes20171213.htm 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm
Highlights A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. Feature BCA's annual Outlook report, outlining the main investment themes that will drive global asset markets in 2018, was sent to all clients in late November.1 In this Weekly Report, we drill down into the specific implications of those themes for global bond markets over the next year. In a follow-up report to be published in two weeks, we will discuss how to piece together those implications into an effective fixed income portfolio for 2018. A More Bearish Backdrop For Bonds, Led First By The U.S., Then By Europe The first major takeaway for bond investors from the BCA Outlook is that the current bullish global backdrop of easy monetary policy, solid growth and low inflation is going to change in the coming year. A robust global economy with broadening inflation pressures will force the major central banks to continue incrementally moving away from extraordinarily accommodative monetary policy settings. This will set up an eventual collision between policy and the markets, the latter of which have benefitted so much from the support of the former during the current bull run for risk assets. The changing monetary backdrop will essentially split 2018 into two halves. The current pro-risk backdrop will be maintained in the first half of the year, with continued above-potential global growth and higher realized inflation in the major developed economies at a time when monetary policy is still too accommodative (Chart 1). This will put upward pressure on global bond yields. There is potential for a significant move higher, as real yields now are too low relative to robust global growth and market-based inflation expectations remain well below central bank inflation targets (Chart 2). Chart 1Central Banks Are##BR##Lagging The Cycle Chart 2Both Global Real Yields AND Inflation##BR##Expectations Are Too Low The trend of rising bond yields will be most acute in the U.S., at least in the first half of 2018. The economy is already operating above potential (Chart 3), and this is before factoring in any impact from the tax cut plan currently being finalized in the U.S. Congress. This fiscal stimulus risks overheating the U.S. economy and will likely encourage the Fed to hike interest rates in 2018 by at least as much as it is currently projecting (75bps after the almost certain rate hike later this month). A faster growth trajectory, combined with a rebound in realized inflation after the 2017 slump, will restore investors' belief that U.S. inflation can move back to the Fed's 2% target. The latter can boost the inflation expectations component of the benchmark 10-year U.S. Treasury yield by as much as 60bps next year. The Fed will feel more emboldened to continue delivering rate hikes if inflation expectations are closer to the central bank's target, thus providing an additional boost to Treasury yields. We project that the 10-year Treasury yield can rise up into the 2.9-3% range, well above the current market forwards. The pressure on global bond yields will not only come from the U.S., according to the BCA Outlook. The booming European economy, freed from the years of fiscal austerity after the Euro Debt Crisis and supported by hyper-easy monetary policy from the European Central Bank (ECB), will continue to grow at an above-trend pace in 2018. Japan is enjoying a very powerful cyclical move (by its own modest post-bubble standards) that should continue given very easy monetary policy, robust profit growth and a historically tight labor market. While China is expected to slow on the back of tighter monetary policy and less fiscal stimulus, growth is still expected to be above 6% in 2018. For all of these economies, inflation is expected to rise alongside growth (to varying degrees) given tight labor markets and diminished levels of global spare capacity. Higher oil prices will also boost global inflation and raise the inflation expectations component of global bond yields, given BCA's above-consensus view on oil prices in 2018 (Chart 4). This will also put bear-steepening pressure on many developed market government bond yield curves as inflation expectations increase, particularly with so many countries operating without much economic slack. This argues for being long inflation protection (i.e. inflation-linked bonds vs. nominals or CPI swaps) in 2018, particularly in the U.S., Euro Area and Japan where inflation expectations are well below central bank targets. Chart 3The Global Output Gap Is Closed Chart 4Rising Oil Will Boost Inflation Expectations The BCA Outlook noted that government bond valuations are poor in most countries, with inflation-adjusted (real) yields well below long-run historical averages (Chart 5). We see higher inflation expectations translating directly into higher global bond yields next year, with little room for real yields to decline as an offset. Chart 5Valuation Ranking Of Developed Bond Markets The latter half of 2018 will see increased worries about future U.S. growth after the Fed has delivered a few more rate hikes and U.S. monetary policy potentially shifts into restrictive territory. At the same time, the strength in global growth and, especially, inflation will cast doubts on the need for continued aggressive bond buying by the ECB and the Bank of Japan (BoJ). Unlike last year, the ECB will be unable to wiggle its way out of the politically difficult decision to begin tapering its asset purchases when the latest program ends in September. Even the BoJ may be forced to alter its current "yield curve control" strategy by raising the target on longer-term JGB yields in response to pressures from better domestic growth and rising global bond yields. Thus, the pressures for higher bond yields will rotate away from the U.S. in the latter half of 2018 towards Europe and possibly Japan. Other developed economy central banks, like the Bank of England (BoE), the Bank of Canada (BoC), the Reserve Bank of Australia (RBA) and the Swedish Riksbank will also be faced with decisions on dialing back monetary accommodation in 2018. Although we anticipate that only the BoC and the Riksbank could credibly deliver on monetary tightening given robust growth and, in the case of Sweden, rapidly rising inflation. Which leads to the second major takeaway from the BCA 2018 Outlook ..... Growth & Policy Divergences Will Create Cross-Market Bond Investment Opportunities The BCA Outlook noted that growth expectations for 2018 still look too cautious in many countries. For example, the IMF is forecasting growth in the developed economies will slow from 2.2% to 2% next year, led by decelerations in the Euro Area, Japan, the U.K., Canada and Sweden (Table 1). At the same time, growth in the emerging economies is optimistically projected to accelerate to a 4.9% pace in 2018, even as China's economy cools to 6.5%. Inflation is expected to modestly increase across most of the world, but remain below central bank targets in many countries. So upside growth surprises, particularly in the U.S. and Europe, will continue to be a major investment theme in 2018. Table 1IMF Global Growth & Inflation Forecasts For 2018 Are Too Pessimistic The growth trends, however, may be more divergent than seen in 2017. This leads to potential cross-market bond trading opportunities by playing relative central bank expectations. The OECD's leading economic indicators are accelerating in the U.S., Europe and Japan; potentially peaking at a very high level in Canada; and outright slowing in the U.K. and Australia (Chart 6). When looking at our central bank discounters, which measure the amount of interest rate changes that are currently priced into money market curves, there are some notable discrepancies with the leading indicators (Chart 7). Chart 6More Divergent##BR##Growth... Chart 7...Will Lead To More Divergent##BR##Monetary Policies The market is now pricing in multiple rate hikes in 2018 from the Fed and BoC, modest increases from the BoE and RBA, and no move from the ECB and BoJ. Given the trends in the leading indicators, rate hikes from the Fed and the BoC are likely, while the BoE and RBA will be hard pressed to raise rates at all next year. Thus, U.S. Treasuries and Canadian government bonds are likely to underperform in 2018, while U.K. Gilts and Australian government bonds can be relative outperformers against a backdrop of rising global bond yields. The outlook for the ECB and BoJ, and the implications for bond yields in Europe and Japan, are a special case that represents the third major takeaway from the BCA Outlook ... The Most Dovish Central Banks Will Be Forced To Turn Less Dovish Chart 8ECB Will Fully Taper By The End Of 2018 The BCA Outlook noted that growth in both the Euro Area and Japan has done very well versus the U.S. over the past four years, essentially matching U.S. growth on a per capital basis (i.e. adjusting for faster population growth in the U.S.). In the Euro Area, an end to the painful fiscal austerity after the 2011-13 sovereign debt crisis was a big driver of the economic strength. The BCA Outlook noted that the drag from tighter fiscal policy during the crisis years was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There has been little fiscal tightening in the following three years, which allowed growth in those economies to catch up rapidly. Add in extremely easy financial conditions - low borrowing rates, a cheap euro, and booming European equity and credit markets - and it is no surprise that the Euro Area economy has enjoyed robust growth over the past couple of years. Looking ahead to 2018, the outlook for Euro Area growth still looks very positive. The OECD leading indicator is rising steadily (Chart 8, top panel). The stock of non-performing loans that has clogged up banking systems in the Peripheral European economies is being whittled down - even in Italy where efforts to fix the many problems of its banks are starting to bear fruit (second panel). At the same time, there will be continued upward pressure on Euro Area inflation in 2018. This will mostly come from higher headline inflation related to higher oil prices (third panel), but also from a grind higher in core inflation and wage growth with the Euro Area unemployment rate already at the OECD's estimate of full employment (bottom panel). The Euro Area economy is likely to expand at an above-potential pace over 2% in the first half of 2018, while headline inflation is set to accelerate back towards the ECB's 2% target. This means that the ECB will have to go through another long conversation with the markets about the future of the asset purchase program. Only the outcome will be different than in 2017 as the economic and inflation arguments for continuing with ECB bond buying will be much harder to justify - especially to the hard money core of the ECB led by Germany. Already, the reduced pace of ECB bond buying set for next year, with the monthly purchases cut in half to €30bn/month, implies a significant slowing of Euro Area monetary liquidity (Chart 9). This will put upward pressure on German Bund yields, but with the move being more concentrated in the latter half of the year as the talk of a true ECB taper, perhaps as soon as the end of 2018, builds. Thus, we see Euro Area government debt being an outperformer in the first half of 2018 and an underperformer in the second half. A move in the benchmark 10-year German Bund yield to the 0.8-1.0% range by year-end is a reasonable target. This would reflect the rise in global bond yields that we expect (i.e. the 10-year U.S. Treasury pushing close to 3%), more normalization in Euro Area inflation expectations and the market pulling forward the timing of future ECB rate hikes. Our base case is still that the ECB will not hike policy interest rates until late 2019, however, which will limit the upside for Euro Area yields next year to some degree. In Japan, the BoJ will continue with its current yield curve targeting regime, aiming to cap 10-year JGBs yields through its bond purchases. This is the most effective way to try and boost Japanese inflation through a weaker yen (Chart 10). The BoJ hopes that this will then lead to rising wage growth as workers demand more pay in response to higher realized inflation. Only if there is a pickup in core/wage inflation in Japan can the BoJ have any chance of reaching its 2% inflation target. Chart 9ECB Tapering Will Put European Yields##BR##Under Upward Pressure Chart 10BoJ Will Keep Rates Low To Boost Inflation##BR##Through A Weaker Yen The current BoJ yield target is around 0% on the 10-year JGB. There has been talk of late from some BoJ officials that the yield target could be raised in response to the strengthening Japanese economy. This is likely just talk to placate BoJ board members who were against the yield curve targeting regime in the first place (it was a very close 5-4 vote to implement the new policy framework in September 2016). Yet the BoJ could conceivable raise the yield target by a modest amount in the context of a bigger move higher in global bond yields. According to a simple econometric model of the 10-year JGB yield unveiled by the BoJ in 2016, a 10bp move higher in the 10-year U.S. Treasury yield would raise the fair value of the JGB yield by 2.7bps (Table 2).2 That model currently shows that JGB yields are about 8bps above fair value (around 0%) at the moment. If the 10yr U.S. Treasury yield were to rise to 3%, however, the current level of the JGB yield would be 7bps too low, which would represent the limit of "overvaluation" on this model since 2013 (Chart 11). Under such a scenario, the BoJ raising the yield target to 0.2%, for example, would not be an unusual response - and it would still be consistent with keeping yield differentials wide enough to generate a weaker yen. Table 2Bank Of Japan 10-Year##BR##JGB Yield Model Chart 11BoJ Could Face Pressure To Raise##BR##The Yield Target If UST Yields Rise In any event, the boost to global monetary liquidity from the asset purchases of the ECB and BoJ will fade next year as both central banks will buy a smaller number of bonds than in 2017. Which brings us to the final main takeaway from the 2018 BCA Outlook .... The Low Market Volatility Backdrop Will End Through Higher Bond Volatility The Outlook noted that the conditions underpinning the growth and liquidity driven bull markets for risk assets will start to turn more negative by mid-2018. Tightening financial conditions, especially as the Fed delivers more rate hikes, will eventually start to weigh on global growth expectations. There is even a very real possibility that the Fed will engineer a U.S. recession in 2019 through tighter monetary policy. At the same time, the Fed will be in the process of its balance sheet runoff, while the ECB and BoJ will be buying smaller amounts of bonds. As we have noted many times this year in Global Fixed Income Strategy reports, a slower growth rate of central bank balance sheets will weigh on the performance of risk assets in 2018 (Chart 12). Add in the risk of growth expectations starting to deteriorate in response to tighter monetary policy in the U.S. (and in China, as well), and markets may become increasingly more volatile later next year - starting with more volatile government bond yields (Chart 13). Chart 12Central Bank Liquidity Tailwind To##BR##Risk Assets Will Fade In 2018 Chart 13The Low Market Vol Backdrop Will End##BR##Through Rising Bond Vol A higher volatility backdrop raises the risk for so many global fixed income markets that have benefitted from investors stretching for yield in order to try and achieve adequate returns. In Chart 14, we show the historical range of yields for global government bonds and spread product (using the benchmark indices for each country or sector) dating back to 2000. The gray dots in the chart represent the current yield for each fixed income category and shows how yields are at historic lows in all markets. Chart 14Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 In Chart 15, we present the historic range of volatility-adjusted yields (the same yields from the previous chart, divided by the trailing 12-month realized index total return volatility of each sector). In this chart, the gray dots again represent the current readings. The blue squares show how volatility-adjusted yields would look if the median volatility of each asset class since 2000 was used in the denominator instead of the latest low level of volatility. Chart 15Historical Range Of VOLATILITY-ADJUSTED Bond Yields##BR##For Various Fixed Income Markets, 2000-2017 As can be seen in the chart, many of the sectors that currently have reasonably attractive volatility-adjusted yields, like U.S. Investment Grade, U.S. High-Yield, and hard-currency Emerging Market debt, will look much less compelling if volatility were to increase to more "normal" levels. The market response will be typical in such a higher volatility environment, as yields would increase to compensate for the greater volatility of returns. The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. In terms of the investment strategy implications, we end this report with a quote taken directly from the 2018 BCA Outlook: "Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018." Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see the December 2017 edition of The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course", available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 The model can be found in this report: https://www.boj.or.jp/en/announcements/release_2016/rel160930d.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Watching The Warning Signals Recommended Allocation Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation
Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Risk assets are responding well to better data and rising rates. Q3 EPS results beating lowered expectations, but growth earnings will peak soon. The conditions are in place for robust capital spending. Financial assets are adhering to the post-Hurricane playbook, with a few notable exceptions. Feature Chart 1Risk Assets Higher Despite Higher Rates Risk assets rose last week for the 6th week in a row (Chart 1). A solid start to Q3 earnings season, more legislative progress on the GOP's tax plan and a narrowing of President Trump's choice for Fed Chair (Jerome Powell, John Taylor and incumbent Janet Yellen) all added to the positive backdrop. The 4 bps rise in the 10 year Treasury yield last week (and 37 bps since early September) was not an impediment to higher equity and oil prices, and gains for small caps and high yield bonds. The positive reaction likely reflected the fact that yields rose more because of increased growth expectations than higher inflation expectations. Despite the impact of Hurricanes Harvey and Irma, Q3 GDP posted an impressive 3% gain. The composition of the Q3 readings suggests an even stronger report in Q4 (Chart 2). At 2.3%, the year-over-year change in real GDP is close to the Fed's 2017 forecast (2.4%) and above the long run forecast (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in December are near 90% and participants expect 51 bps more hikes in the next 12 months (Chart 1, panel 3). BCA's view is that U.S. economic growth is set to accelerate in the coming quarters aided by a post hurricane rebound in housing. The Fed will raise rates in December and three more times next year as inflation returns to 2% and perhaps beyond. Corporate profit growth will peak in the next few quarters, but remain supportive of higher stock prices for now. The rise in the Economic Surprise Index will continue for another few months, and provide another lift for risk assets. A surge in capital spending adds to the upbeat tone. Chart 2GDP Growth Remains Below Average, But Above Fed's Long Run Target Capital Spending Blasts Off Business capital spending is on the upswing. The robust readings in September on core durable goods orders (7.8% year-over-year) and shipments reported last week were paybacks for the Hurricane-weakened August report. Nonetheless, the impressive soundings on the three -month change in both orders and shipments were not distorted by the storms. Moreover, the durable goods report was one of the latest in a series of data points brightening capex's outlook (Chart 3). Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM readings and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters. CEO confidence soared to a 13-year high in Q1 according to the latest Duke University/CFO Magazine Business Outlook, but retreated modestly in Q2 and Q3 (Chart 4). Surveys by the Conference Board and Business Roundtable show a similar pattern. Notably, readings on all three surveys have climbed since Trump's election in November 2016, but then retreated as his pro-business agenda stalled. The drop in sentiment reflects the lack of legislative progress in Washington (Chart 5). The dip in CEO sentiment in Q2 and Q3 is in sharp contrast with the easing of policy concerns in the Beige Book. Chart 3Bright Outlook For Capital Spending Chart 4Capital Spending Plans Upbeat Chart 5Managements Remain Upbeat The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support rising capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are close to cycle highs, despite a modest pullback in the summer months. Moreover, the regional Feds' capex spending plans diffusion index hit an eight-year high in October (Chart 5, panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. Rising capex will drive up GDP, employment and EPS in the coming quarters. Q3 Earnings Beating Lowered Expectations The Q3 earnings reporting season is off to a strong start, with both EPS and sales growth well ahead of consensus expectations as we forecast in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Just under 55% of companies have reported results so far, with 74% beating consensus EPS projections just above the long-term average of 55%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the LT average of 69%. The surprise factor for Q3 stands at 5% for EPS and 2% for sales. These compare favorably with the average EPS (4.2%) and sales (1.2%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, initial results imply that Q2 will be another quarter of margin expansion. Average earnings growth (Q3 2017 versus Q3 2016) is solid at 7% with revenue growth at 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in eight of the 11 sectors. The 7.3% year-over-year drop in the financial sector is linked to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up 4.7% from a year ago. EPS results are particularly stout in energy (164%), technology (18%) and healthcare (7%). Those sectors likewise experienced significant sales gains (16%, 9% and 5% respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 6). Trump's name was mentioned just once in the Q3 earnings calls held through October 27, matching Q2's reporting period. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The peak in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 6Managements Focused On##BR##The Message Out Of DC In contrast, the words "tax" and "reform" have appeared 39 times thus far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2, when there was skepticism that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.1 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 7). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 figure. That said, the divergence can be explained by the impact of the hurricanes on the financial sector's earnings in 2017 and probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from 2018's clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.2 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 toward a level commensurate with 3 ½-4% nominal GDP growth (Chart 8). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. The entire Treasury curve has readjusted to reflect this view. Chart 7Stability In '17 & '18 EPS Estimates,##BR##But '19 Likely To Move Lower Chart 8Strong EPS Growth Ahead,##BR##Will Start To Slow Soon 10-Year Treasury Update BCA's view is that the 10-year Treasury yield will head higher in the coming months. However, is the move from 2.03% in early September to 2.43% last week sustainable? BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) places fair value at 2.65% (Chart 9, panel 1). Moreover, BCA's three-factor version of the model (that includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.63% (Chart 9, panel 3). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Chart 9Treasury Fair Value Models BCA's U.S. Bond Strategy service will publish updated fair models after the November 1 release of October's global PMI data. The latest readings on Citi's Economic Surprise index also support BCA's stance on rates. How Long Can The Economic Surprise Index Stay Positive? The Citi Economic Surprise Index crossed into positive territory on October 2nd, remaining above zero for 20 business days, and risk assets are responding (Chart 10). Since 2010, once the Index turns positive, it continues to rise for 46 days. The implication for investors is that the economic data will continue to be remarkable for another two months. Table 2 shows that risk assets outperform as the economic surprise index rises from zero toward its zenith. Risk assets have also outperformed since the June bottom in economic surprises, matching the historical performance.3 Oil (+17%), small caps and investment grade corporates are all standouts and the gains may not be over. The track record of risk assets as the Economic Surprise Index climbs suggests that additional increases are in prospect for risk assets. On average, equities (relative to treasuries) and oil are the best performers during these intervals. Chart 10May Still Be Room To Run On Economic Surprise Table 2Risk Assets Perform Well As Economic Surprise Rises Post-Hurricane Macro Backdrop The strength of the Citi Economic Surprise Index following the hurricanes duplicates the historical trend and supports the rise in risk assets. The Index moves higher for the first month post-storm, and then remains above zero for an additional three weeks (Chart 11, panel 4). This bolsters BCA's stance that the direction of the Index will continue to lift risk assets in the next few months. Financial assets are also adhering to the post-Hurricane playbook,4 with a few notable exceptions (Chart 12). The stock-to-bond ratio moved higher and the VIX has declined since Hurricane Harvey, matching the typical post-storm performance. However, the 10-year Treasury yield, the S&P 500 and the Fed funds rate, all have bucked historical trends. The S&P 500 rose by 5.6% since late August; stocks typically drift lower in the first few months after a major storm. In addition, the 10-year Treasury yield climbed but it usually moves down in the two months following a hurricane. Post- storm, the Fed typically continues to do whatever it was doing prior to the storm. Accordingly, we expect the Fed to hike rates at its December meeting. Chart 11Major Hurricane Impact##BR##On Activity Data Chart 12Major Hurricane Impact On##BR##Financial Markets And The Fed The economic, inflation and sentiment data are also mixed. Housing data frequently lags in the wake of a storm, but both new and existing home sales moved up in the month after Harvey and Irma; housing starts declined in recent months which is counter to the historical pattern (Chart 13). Both IP and employment plunged after the storms, however, these indicators tend to rise after major weather. Initial claims for unemployment insurance were typically volatile in the six weeks since Harvey hit Texas, but have resumed their downtrend. Average hourly earnings in inflation climbed after Harvey and Irma, while consumer confidence dipped, matching history. However, the bump in gasoline prices since late August runs counter to historical precedent. Gasoline prices tend to decline after major storms (Chart 14). Chart 13Major Hurricane Impact##BR##On Housing Data Chart 14Major Hurricane Impact On##BR##Sentiment And Inflation Data Investment Conclusions: The macro backdrop remains bullish for risk assets, especially since synchronized growth has reduced fears of secular stagnation. Bond yields will rise, but won't be a headwind for stocks yet.5 Rising bond yields because of growth, without rising inflation, are bullish for risk assets, but this will change as inflation reaches 2% and inflation expectations start to rise. At that point, the Fed will be behind the curve. This will lead to faster Fed rate hikes, historically a headwind for equities. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," April 17, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot" June 19, 2017. Available at usis.bcaresearch.com.
Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights It's ok to ignore the September jobs report. Is the small cap comeback sustainable? Assessing the threat to the consumer from higher rates and oil prices. The ISM is over 60, now what? Feature Risk assets outperformed again last week, as the S&P 500, the dollar, and the 10 year- Treasury yield all moved higher. Oil was an exception, as WTI dipped back below $50 per barrel, but BCA's Commodity & Energy Strategy service expects WTI to end the year over $55/bbl. Small-cap stocks outperformed as well and conditions are in place for the rise in small caps to continue. The rise in risk assets in recent weeks occurred alongside a marked improvement in the Citi Economic Surprise Index (Chart 1), which moved into positive territory last week for the first time since April, despite the impacts of Hurricanes Harvey and Irma. Chart 1S&P And 10 Year Treasury Yield Tracks Economic Surprise The lack of impact from the hurricanes on the economic data is surprising. Before Hurricane Harvey made landfall, the Atlanta Fed GDP Now reading for Q3 was 3.4%, but moved as low as 2.1% in late September as the August economic data was reported. The most recent Atlanta Fed forecast pegged Q3 GDP at 2.5%. The 60+ readings on September's manufacturing ISM composite and 70+ reading on prices were notably strong, as was the 18.6 million reading on September vehicle sales, the strongest in 12 years. That said, the impact of the storms was evident in the employment data released last week (See below). U.S. Jobs Report: All Noise, No Signal U.S. nonfarm payrolls fell 33,000 in September, which was entirely due to the hurricanes. According to the BLS, 1.47 million workers could not show up for their jobs due to the weather. Because this data series is not seasonally adjusted, one cannot simply add it back to the headline payrolls number. Unfortunately, the separate household survey does not help to shed any better light on the state of the labor market. The household survey is known to be much more volatile than the establishment survey. This was quite apparent with the 906,000 surge in jobs, which followed a 74,000 decline in the previous month. The outsized and unbelievable surge in household employment was the main reason for the decline in the jobless rate to 4.2% from 4.4%. The labor force actually grew by a hefty 575,000 and the participation rate rose to 63.1%, the highest since March 2014 (Chart 2). The 0.5% m/m gain in average hourly earnings needs to be discounted as well. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. As these workers return to their jobs, average hourly wages will correct lower. Bottom Line: Investors should ignore the September jobs report. The 3-month average of payrolls growth from June to August was 172K. This is probably the best gauge of underlying jobs growth and this pace is above the trend growth in the labor force. To the extent that the Fed believes the tightening labor market will push inflation to its 2% target, the calculus for the December FOMC should not change after today's report. Small Caps Make A Comeback Rising prospects for tax cuts have lifted the Trump trades, including small-cap equities. We first initiated an overweight to small caps on November 14, 20161 (Chart 3). Since then, small caps have underperformed large by 162 bps, but not uniformly. The trade was successful from the start through to late January, but faded by late summer along with the prospects for Trump's tax cuts. Starting in mid-August, small cap made a comeback as odds of the tax cut troughed. Chart 2The September Jobs Report Is More Noise Than Signal Chart 3The Trump Trades Are Back On Several factors support our overweight view. According to BCA's U.S. Equity Strategy service S&P 600 valuation indicator, small caps are even more undervalued today than when we last discussed them in June2 (Chart 4). Moreover, the Cyclical Capitalization Indicator (CCI) moved sharply into positive territory following the U.S. election despite a modest dip in subsequent months (Chart 5). In addition, small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (Chart 5, panel 2). That characteristic of small caps argues for a bullish stance given our upbeat view on growth and our overweight positions in U.S. equities versus bonds. BCA's outlook for regulation, inflation, the dollar, the Fed and the consumer also favor small over large caps. Trump has already made significant progress in slowing the pace of new regulations,3 which has long been a concern for small businesses. We expect inflation to move back to 2% in the coming quarters and then begin to climb higher in 2018. Chart 6 shows that small caps often thrive when inflation accelerates. BCA's outlook is that the dollar will see modest appreciation over the next 12 months. Small-cap stocks are less sensitive to dollar movements than large caps. Gradually rising rates will not impede small caps and credit conditions remain favorable. Finally, small caps are more closely linked to the consumer than the S&P 500, and BCA's view on household spending remains upbeat. Chart 4Small Caps Are Cheap, But Not Historically Cheap Chart 5Our CCI Supports Small Caps Chart 6Accelerating Inflation Usually Supports Small Caps Despite the upbeat prospects for small caps, some risks linger. Tighter credit conditions for consumers and businesses, an abrupt pullback in housing that would trigger a consumer retrenchment, persistent weakness in the dollar, and a "risk off" environment would see small caps underperform large caps. Bottom Line: It is too early to abandon our bullish bias toward small caps. Conditions remain in place for small caps to outpace large caps. Favorable valuation and encouraging prospects for Trump's pro-small business platform are key to BCA's view, as our favorable outlook for the U.S. consumer. Will Higher Rates And Oil Prices Crush The Consumer? Supports remain in place for continued strength in U.S. consumer spending despite rising interest rates and oil prices. That support was confirmed by September's reports on employment and vehicle sales, and August's personal income and spending data, all released in the past two weeks. However, investors should be aware of hurricane-related distortions in the August and September figures.4 Moreover, BCA's position is reinforced by elevated readings on consumer confidence and booming household net worth statistics, and record high FICO scores (Chart 7). The conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 8 shows that at 41%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by 1.3 percentage points since 2012. In contrast, spending on necessities rose by a record 3.5% in the five years ending in 2008, matching the bruising impact of higher rates, surging inflation and soaring oil prices seen by the end of 1980. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of the consumer.5 Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will provide a boost to disposable income. Personal tax cuts as part of the plan Trump proposed last month would also enhance incomes. Chart 7Plenty Of Support For The Consumer Chart 8Consumer In Good Shape Despite Rise In Oil, Rates BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. The latest reading on the manufacturing ISM composite and the 60+ readings on the new orders component of ISM since February suggest that managements are starting to note the robust pace of consumer spending. Signals From Elevated ISM Readings September's numbers on the ISM manufacturing index support BCA's case for accelerating corporate profits in the coming quarters. The ISM is a good proxy for industrial production, which in turn tracks S&P 500 sales. The recent strong data on ISM suggests that IP should pick up in the next six months (Chart 9). A rollover in the 12-month change in IP would challenge our constructive stance on earnings. While a decline is possible given that the index is already lofty, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 10). Chart 9Favorable Macro Backdrop For Earnings And Sales Chart 10ISM Components Suggest IP Poised To Accelerate Some investors question how long the composite and new orders indices will remain beyond 60 and what that will mean for risk assets. Additionally, the second 70+ reading on the ISM Prices index this year challenges the notion that inflation is dormant. Other investors are concerned about what will happen after these ISM components are so elevated. Others may fear that the index will soon fall below 50. We analyze the historical periods when the ISM and its sub-indexes were above the 60 threshold, and then what happens to the returns of risk assets 12 months after they fall below the 60 threshold (Chart 11A, Chart 11B and Chart 11C). Chart 11AComposite ISM And Risk Assets Chart 11BISM New Orders And Risk Assets Chart 11CISM Prices And Risk Assets Historically, the relative performance of large cap equities to Treasuries is typically poor when the ISM Manufacturing Composite Index is over 60, but investment-grade credit outperforms and both gold and oil usually gain. The performance of these assets is similar even excluding the period around the 1973 OPEC oil embargo and the 1987 stock market crash (Chart 11A and Appendix Table 1). The ISM Manufacturing Composite Index ticked up to 60.8 in September, the first 60+ reading since 2004. The indicator also reached 60 three times in the 1970s and twice in the 1980s, and it stayed above 60 on average for 8 months. The last time it breached 60, it remained at that level for 6 months (December 2003 through June 2004). That interval, along with most of the others, was accompanied by tightening monetary policy and accelerating inflation late in the latter half of economic cycles. Gold and oil perform strongly in the 12 months after ISM Composite Index goes below 60, large-cap equities barely do better than Treasuries, while investment-grade credit underperforms. Surprisingly, high-yield bonds and small-cap stocks outperform 12 months after the ISM falls back below 60, although the sample size is limited. In 1974-1975, the economy was in recession. In all but one other instance (the mid- 1980s), the economy was in a late stage of the cycle, nearing full employment and inflation was on the rise. Risk assets also are strong performers when the New Orders component of the ISM exceeds the 60 threshold (Chart 11B and Appendix Table 2). Moreover, the episodes are more numerous (14 since 1971 versus only 6 for the composite) but, on average, they persist as long as the signal from the ISM Composite. New Orders have been above 60 since February 2017 (7 months), just shy of the 46-year average (8 months). Large cap equities and credit (both investment-grade and high-yield) have outperformed Treasuries, and gold has climbed since February. This performance matches the historical pattern when the New Orders index exceeds 60. In the past 8 months, the underperformance of small caps and the drop in oil prices in that span runs counter to history. The performance of risk assets in the year after the new orders index moves below 60 is mixed, at best. In these periods, while the S&P 500 outperforms Treasuries on average, and small caps outperform large caps, credit underperforms. The big winners when the New Orders index is falling from over 60 are gold (average 14% gain) and oil (22%). Chart 11C and Appendix Table 3 shows the performance of risk assets when the ISM Prices index is greater than 70 and then 12 months after the index crosses below 70. Gold and oil are standouts in the first case, and small cap tends to outperform large. Note that 3 of these 11 episodes coincided with recessions (early 1970s, 1980 and 2008) and 1 occurred during the 1987 stock market crash. Small-cap equities continue to outperform as the Prices index fades, and returns on gold and oil are muted. High-yield bonds underperform Treasuries when the ISM Prices index dips back below 70, and the total return on investment-grade corporate struggles, but it beats Treasuries. Moreover, 3 of these 11 occurred during recessions (early 1980s, 2001, 2008-2009). Separately, there has been a tight relationship between the 12-month change in the 10-year Treasury yield and both the overall ISM, the New Orders and Prices component of the ISM in the past 25 years (Chart 12). Nonetheless, the relationship between the ISM Prices component and the 10-year Treasury has broken down since oil prices peaked in 2014. The 12-month jump in ISM Prices surge in 2016 was met with a decline in Treasury yields. Prior to that, a rise in Prices index was almost always accompanied by a move higher in bond yields. BCA's view is that the ISM manufacturing Composite will remain elevated (although not necessarily more than 60 in the months ahead), supporting our bullish stance on corporate sales and earnings. However, if we are wrong and the ISM dips below 60 and then down to 50, would that signal a downturn and concomitant selloff in risk assets? The ISM has a mixed track record as a leading indicator of recessions (Chart 13). Since 1948, the ISM has provided 9 false signals, using 3 consecutive months below 50 as the indication of an economic decline. Furthermore, 5 of the 9 examples occurred since 1985, as the U.S. economy became less reliant on manufacturing. In the 6 instances that the ISM warned of contractions, the average lead time was 4 months. In the 4 other economic slumps, the ISM moved and stayed below 50 for 3 consecutive months only after the start of recession. The lag averaged 4 months. This was the case in the 2007-2009 episode when the ISM did not send a recession signal until May 2008, 5 months after the official start of the downturn. Chart 1210 Year Treasury Vs. ISM Chart 13The Rocky Relationship Between ISM And Recessions Bottom Line: Elevated readings on ISM support BCA's view that profit growth will accelerate for a few more quarters while the recent rise in the ISM Prices index confirms the move higher in Treasury yields. Stay overweight stocks versus bonds and underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," November 14, 2016. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Waiting For The Turn," June 26, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still Waiting for Inflation, "August 14, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From the Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Monthly Report, "Global Debt Titanic Collides With Fed Iceberg?," February 2017. Available at bca.bcaresearch.com. Appendix: Table 1 Table 2 Table 3
Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades