Developed Countries
We have been shifting our portfolio toward a cyclical over defensive tilt recently and in this week's Special Report, we are highlighting five compelling reasons to buy cyclicals at the expense of defensives. Capital expenditures upcycle. The capex upcycle will disproportionately benefit capital goods producers versus their defensive brethren. Leading indicators of capital outlays have taken off (top panel), suggesting both capex and the relative share price ratio will surge higher. Synchronized global growth in general and emerging markets (EM) growth in particular. Synchronized global growth typically boosts global final demand and is also conducive to a coordinated global capex upcycle. The resurgent global manufacturing PMI suggests that cyclicals have the upper hand (second panel). U.S. dollar softness. The U.S. dollar has a critical influence on the relative share price ratio. The currency remains in the red year-to-date, on a trade-weighted basis, representing a bullish backdrop for cyclical compared with defensive EPS prospects as a lagged currency effect should boost relative profitability (third panel). Bottom Line: Shift to a cyclical over defensive portfolio bent. Please see yesterday's Special Report for more details and our other reasons for the portfolio shift.
Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights High-Yield: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. EM Sovereigns: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Feature Chart 110-Year Treasury Yield Breakdown Just past the three quarter mark of 2017 and stubbornly low inflation remains the story of the year in U.S. bond markets. Quite simply, if inflation rebounds during the next two-and-a-half months, as the Federal Reserve expects, then Treasury yields will move sharply higher and Treasury total returns for 2017 will be close to zero. Otherwise, yields are likely to remain near current levels and 2017 Treasury total returns will approximate carry, in the range of 2.5%. Our valuation framework for the 10-year Treasury yield underscores the importance of inflation for the duration call. The real 10-year Treasury yield (currently 0.43%) is consistent with market expectations for just under two Fed rate hikes during the next 12 months (Chart 1). With the median Fed member calling for 3-4 hikes during that period, the potential remains for somewhat higher real yields in the near-term. But with all but one Fed member forecasting a terminal fed funds rate of 3% or below (1% or below in real terms), the long-run upside in real yields appears limited. On the other hand, the compensation for inflation embedded in 10-year bond yields is still far too low. At 1.85%, the 10-year TIPS breakeven inflation rate is well below the 2.4% to 2.5% range consistent with the Fed hitting its inflation target. This continues to be the case even as our Pipeline Inflation Indicator has accelerated in recent weeks (Chart 1, bottom panel). Bond investors are waiting for inflation to show up in the core CPI and PCE data before liquidating their positions. We retain our below-benchmark duration bias on a 6-12 month horizon on the view that inflation will soon resume its cyclical uptrend. 10-year inflation compensation has 55-65 bps of upside in this scenario, while 10-year real yields will probably stay close to current levels. The outlook for core inflation is discussed in more detail in the Economy & Inflation section below. High-Yield: Just A Carry Trade At this late stage of the credit cycle, low inflation is also the key support for excess returns in both investment grade and high-yield corporate bonds. We see limited scope for further spread tightening but think it's likely that the carry trade will continue until inflation turns the corner and long-maturity TIPS breakevens settle into the 2.4% to 2.5% range consistent with the Fed's target.1 In this week's report we explore what this carry trade means for excess high-yield returns, and put those returns into context with what the asset class has typically delivered for bond investors. Table 1 shows historical annual excess returns for the Bloomberg Barclays High-Yield index since 1995.2 On average High-Yield has returned 3.42% over Treasuries each year, but with significant variation. Most of that variation results from years when the default rate is either rising quickly during a recession or falling fast in the early stages of economic recovery. Since neither of those scenarios is likely during the next 6-12 months we filter out those periods by looking at years when the average index option-adjusted spread (OAS): Widened by more than 100 bps Tightened by more than 100 bps Was range bound between -100 bps and +100 bps The average excess return is 4.9% in years when the spread is confined to a -100 bps to +100 bps range. High-Yield has returned 5.46% in excess of Treasuries so far this year, and the OAS has tightened 61 bps. It is unlikely that junk spreads will tighten by 100 bps or more during the next 12 months. The average index OAS is currently 348 bps, only 115 bps above its all-time low (Chart 2). However, to properly assess current spread levels we also need to consider that the average index duration has declined during the past fifteen years. All else equal, the same spread level is more attractive today because index duration is lower. Table 1Historical Annual High-Yield##br## Excess Returns* (%) Chart 2Junk Spreads Not Far ##br##From All-Time Tights We adjust for index duration by looking at the 12-month breakeven spread.3 At 93 bps, the breakeven spread is currently 40 bps above its all-time low (Chart 2, bottom panel). In other words, at current duration levels, the junk OAS can tighten another 149 bps before the sector is more expensive than it has ever been. Either way, what's clear from Chart 2 is that we should probably not expect much more than 100 bps of further tightening this cycle. Or, put differently, it would definitely make sense to reduce high-yield exposure as we approach all-time expensive valuations. But we can get even more specific about our expectations for high-yield excess returns. Excess junk returns can be approximated using the following formula: Excess return = Starting OAS - Default Losses - Duration*(Change in OAS) The expected return from carry during the next 12 months can be thought of as today's index spread less our expectation for default losses. Capital gains and losses can be approximated using today's index duration and the expected change in spreads. For simplicity we ignore convexity effects. This excess return approximation is shown in the second panel of Chart 3, where the dashed line assumes a base case scenario where default losses fall in line with our expectation and the OAS remains flat. Table 2 shows what 12-month excess returns would be in this base case scenario, as well as in several other scenarios. Chart 3High-Yield ##br##Expected Returns Table 2High-Yield 12-Month Excess ##br##Return* Projections In a base case scenario, where default losses are 1.09% and the OAS is flat, we would expect excess junk returns of 2.39% during the next 12 months. In a more bullish scenario where the OAS tightens by another 100 bps - bringing it to within striking distance of all-time tights - we would expect excess returns of 6.15%. We also consider scenarios where default losses differ from our forecast of 1.09%. For context, that 1.09% forecast is derived from Moody's baseline default rate forecast of 2.26% and our own model-based recovery rate forecast of 51%. For example, in a scenario where default losses are somewhat higher than expected (2%) but where the OAS stays flat, we would expect excess returns of only 1.48%. We should note that 12-month high-yield default losses have never been lower than 0.5%. So we present that optimistic scenario as an upper-bound on potential excess returns to junk. Notice that even in the most optimistic scenario we can envision, default losses reaching all-time lows and spreads contracting to within a hair of all-time tights, expected excess high-yield returns still only reach 6.74%. We would view that as the absolute best case scenario for high-yield. Realistically, default losses will probably fall into a range between 1% and 2% during the next 12 months. Assuming also that spreads come under neither strong upward nor downward pressure, we would expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Bottom Line: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Is Hard Currency EM Debt A Substitute For Junk? Chart 4Favor U.S. Corporates Over EM Sovereigns With relatively feeble expected returns from U.S. high-yield bonds, it's logical to explore whether there are any more attractively valued alternatives in the U.S. bond universe. One potential candidate is the U.S. dollar denominated debt of Emerging Market governments. Unfortunately, valuation in that space does not look much better than in U.S. corporates. In an effort to control for differences in both credit rating and index duration, we compare 12-month breakeven spreads between the Bloomberg Barclays EM USD Sovereign Index and a credit rating matched benchmark consisting of a combination of U.S. investment grade and high-yield corporate bond indexes. We notice that hard currency EM Sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year (Chart 4). At the moment there is no compelling argument to favor one sector over the other on pure valuation grounds. We therefore also consider the main macro drivers of relative excess returns between EM Sovereigns and U.S. corporates (Chart 4, bottom 2 panels). The last two significant periods of EM outperformance coincided with falling U.S. rate hike expectations - as evidenced by our declining fed funds discounter - and a weaker U.S. dollar. With our 24-month fed funds discounter at only 62 bps - meaning the market expects less than three rate hikes during the next 24 months - we think it is likely to move higher from here. This should lead to one more bout of EM cheapening relative to U.S. corporates. At that point, once we are past peak rate hike expectations for the cycle, we will likely get a more attractive entry point to move into EM. Interestingly, an examination of country level spreads also does not identify any clear pockets of cheapness in EM (Chart 5). Mexico and Turkey both offer similar breakeven spreads to equivalently rated U.S. corporates, but our Emerging Markets Strategy service has a dim view of both the Turkish Lira and Mexican peso versus the U.S. dollar.4 The higher-rated EM countries: Saudi Arabia, UAE and Qatar offer the most attractive relative spreads. But, at least for Qatar, that elevated spread is most likely compensation for a highly volatile currency (Chart 6).5 Chart 5Breakeven Spreads: USD EM Sovereign Vs. U.S. Corporates Chart 6USD EM Sovereign Breakeven Spread Differentials Vs. Exchange Rate Volatility Bottom Line: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation Some Silver Linings In September's CPI The September CPI report was released last week and it disappointed expectations with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. However, despite the disappointing month-over-month figure, we continue to see evidence that inflation is past the worst of its recent downtrend. First, while year-over-year core CPI was roughly flat in September, the 3-month rate of change increased for the fourth consecutive month. The year-over-year rate of change tends to converge toward the 3-month rate of change (Chart 7). Second, a look at the underlying components of core CPI shows the following (Chart 8): Chart 7CPI Inflation Chart 8Core CPI Components Shelter inflation fell from 3.30% to 3.24% year-over-year in September. This mild deceleration is consistent with the reading from our model, and will persist going forward (Chart 8, panel 1). Chart 9Wireless No Longer A Drag Core goods inflation also fell in September, but should soon start to rise as the weaker dollar and rising import prices pass through to overall core goods prices (Chart 8, panel 2). Core services inflation, excluding shelter and medical care, increased for the third consecutive month (Chart 8, panel 3). This component of inflation is most sensitive to wage growth, and it is where we would expect most of the inflation to come from going forward. Medical care inflation continues to decelerate sharply (Chart 8, bottom panel), but as we have discussed previously, this mostly reflects a convergence between CPI and PCE inflation.6 The Fed's 2% target refers to PCE inflation. The acceleration in core services inflation (excluding shelter and medical care) is particularly important as it is yet another signal that tight labor markets are starting to pressure wages higher. This is the dynamic that must continue to play out if inflation is to return to the Fed's target, and we would tend to view increases in inflation as more sustainable if they are driven by this component. Additionally, the critical core services inflation (excluding shelter and medical care) component has been depressed in recent months by an incredibly sharp decline in cellular service (aka wireless) inflation (Chart 9). The decline occurred when both Verizon and AT&T unveiled unlimited data plans in the same month, but that drop has since reversed. When we exclude wireless from core services inflation, in addition to shelter and medical care, we see that the resulting series tracks wage growth much more closely in recent months. This underscores our conviction that core services inflation will respond to tightening labor markets and mounting wage pressure going forward. Consumer Sentiment Is Sky High There was one other notable datapoint released last week, and that was the University of Michigan's Consumer Sentiment survey which surged to its highest level since 2004 (Chart 10)! This should lend support to consumer spending (and hence GDP growth) in Q3 and Q4 and is consistent with the message from the New York Fed's GDP tracking estimate which projects GDP growth to average 2.3% in the second half of 2017. This is well above the Fed's 1.8% estimate of trend. Chart 10Consumer Spending & Sentiment With growth coming in solidly above trend, it is unlikely that September's disappointing month-over-month CPI print will be enough to prevent the Fed from lifting rates in December. As long as inflation is flat or higher during the next two months, then another rate hike this year is probably in the cards. Bottom Line: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 2 Excess returns are calculated relative to a duration-matched position in Treasury securities. 3 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon to deliver zero excess returns. For simplicity we ignore convexity effects and calculate the breakeven spread as OAS divided by duration. 4 For Turkey please see Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017. For Mexico please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017. Both available at ems.bcaresearch.com 5 Both Saudi Arabia and UAE have pegged exchange rates and are not shown in Chart 6. 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on 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, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 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. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.
Overweight - High-Conviction The S&P asset management and custody banks (AMCB) index has outperformed both the S&P 500 and the broad financials index since we lifted it to a high-conviction overweight in mid-February. The tight correlation between Treasury yields and relative share prices explain a large part of the outperformance (top panel). Given BCA's underweight duration bond view, we still think the outperformance phase is in early days. Historically, the index has also been positively correlated with both the stock-to-bond ratio and the equity risk premium, but has deviated significantly from both in the last four years (second and third panels). The index has also diverged negatively from its own earnings profile, creating a persistent state of undervaluation since 2015. Even modest mean reversion in any of these measures implies substantial outperformance as animal spirits remain upbeat. Bottom Line: The undervalued S&P AMCB index has significant catch-up potential with earnings momentum pointing in the right direction. Stay overweight. The ticker symbols for the stocks in the S&P asset manager & custody banks index are: BLBG: S5AMGT-BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG.
Highlights It is often argued that the U.S. dollar is expensive, but models do not offer a unanimous picture. The U.S. current account, exports share, and cyclical inflation do not point to an obvious dollar overvaluation either. Without a clear valuation signal, the dollar will continue to trade off rate differentials. An increasing body of evidence points toward a rebound in U.S. inflation. As such, U.S. rates are likely to move up relative to the rest of the world, lifting the USD over the next 12 months. Feature We are sending you a shorter regular bulletin this week as we are also publishing a follow up to our joint Special Report titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," released with the Global Asset Allocation team two weeks ago. In this follow-up, my colleague Xiaoli Tang expands on the same methodology, testing various FX-hedging strategies for international investors - but this time looking at portfolios based in the CHF, the SEK, and the NOK. In this week's regular bulletin, we take a closer look at the U.S. dollar's valuations. The consensus view is that the dollar is expensive. We explore how this claim stacks up against the facts. At this juncture, the U.S. economy is not exhibiting some of the key consequences typical of an economy burdened by an expensive currency. Valuation Models The main argument used by some investors to show that the U.S. dollar is expensive is the traditional purchasing power parity model. This indicator does indeed flag a large 17% overvaluation for the greenback (Chart I-1). However, this is only one metric based on producer price indices. We also like to look at measures that focus on the true determinant of competitiveness: the cost of labor. When we deflate the U.S. dollar's exchange rate using unit labor costs, the dollar is neither a screaming sell nor a screaming buy. It is in line with its long-term average (Chart I-2). The same IMF real effective exchange rate model based on unit labor costs also shows the euro as fairly valued. Thus, on this metric, valuations do not seem to provide a compelling argument to go long or short the dollar, which challenges the universally bearish take on the dollar's perceived overvaluation. Chart I-1An Argument For An###br## Expensive USD Chart I-2But Not All Valuation Approaches ##br##Are That Clearcut We can also double-check the result of this metric using our own long-term fair value model, which incorporates long-term relative productivity trends. This model tries to capture the so-called Balassa-Samuelson effect. This effect is an empirical observation that countries with superior long-term labor productivity trends tend to experience a secular upward bias on their real exchange rates. The perceived overvaluation of the U.S. dollar may in fact be an illusion, because when the Balassa-Samuelson effect is taken into account, the dollar currently trades in line with its fair value (Chart I-3). Chart I-3Another Global Approach With USD At Fair Value Bottom Line: Valuing currencies is always an exercise to be approached with plenty of circumspection. It is easy to look at simple PPP models and argue that the dollar looks very expensive. However, when one takes into account labor market costs and productivity trends, the dollar seems fairly valued. A Look At The Symptoms Chart I-4The U.S. Current Account##br## Shows Little Dollar Strain Models are only as good as their inputs. It is important to try to corroborate their insights with economic reality. An expensive currency should produce three major outcomes: the country's current account position should be deteriorating, its market share of global exports should be falling, and it should be experiencing deep deflationary pressures relative to the rest of the world. Let's begin with the current account. Despite a 17% increase in the U.S. dollar since 2014, the U.S. current account has remained stable (Chart I-4). It is undeniable that this reflects an improvement in the energy trade balance of the U.S., itself a byproduct of the shale revolution. Nonetheless, it also highlights that there is little balance-of-payments strains in the U.S. In fact, the move away from energy imports in itself should point to a higher level of equilibrium for the dollar. The export share of the U.S. also does not point to too much stress created by the dollar bull market. As Chart I-5 illustrates, in contrast to the early 1980s or late 1990s-early 2000s, U.S. exports has been faring well when compared to the rest of the world. This exercise needs to be conducted by comparing U.S. exports to the rest of the world excluding China. China has been grabbing global market share from everyone for 30 years. As an aside, the continued rise of China, as well as its still-large current account surplus of more than US$155 billion, supports the idea that the RMB is indeed cheap and remains attractive on a long-term basis - a message also flagged by our long-term fair value model for the CNY (Chart I-6). Chart I-5Growing U.S. Market Share Chart I-6The Yuan Is Clearly Cheap Finally, there is little evidence that the U.S. dollar is depressing U.S. inflation on a cyclical basis. Changes in financial conditions can temporarily redistribute inflationary pressures between the U.S. and the rest of the world, but an expensive dollar should depress U.S. inflation for an extended period of time on a global relative basis. An expensive U.S. dollar makes the U.S. uncompetitive, and should force some degree of internal adjustment on the U.S. economy. So far, the two-year moving average of U.S. core inflation relative to the OECD does not show the same kind of swoon as in the 1980s or late 1990s. In fact, even after this year's inflation slowdown in the U.S., American inflation remains in an uptrend relative to the rest of the OECD (Chart I-7). One source of worry remains the U.S. net international investment position (NIIP). The U.S.'s NIIP currently stands at -41% of GDP, and despite stabilizing for the past two years, has been in a pronounced downtrend over the past 35 years. Historically, countries like Switzerland or Japan with strong NIIPs have tended to experience long-term upward pressure on their exchange rates, while those with poor NIIPs such as South Africa tend to experience negative secular trends, even in real terms. For the time being, what keeps the negative impact of the NIIP on the USD at bay is that the U.S. continues to earn a positive net income - despite negative net assets abroad (Chart I-8). This reflects the willingness of investors to hold the U.S. dollar for its reserve currency status. For the time being, with a lack of alternative to challenge the U.S. dollar's reserve status, the NIIP should not represent a key hurdle for a few more years. Chart I-7The U.S. is Not Experiencing##br## An Internal Devaluation Chart I-8The Exorbitant ##br##Privilege Bottom Line: The U.S. economy is currently exhibiting few of the signals that would be associated with an expensive dollar: the current account remains well behaved, the country is not losing export market shares to its main competitors, and U.S. inflation remains well behaved relative to the rest of the OECD on a cyclical basis. A key risk remains the U.S.'s net international investment position, but so long as the USD can maintain its unchallenged role as the key reserve in the global financial system, the U.S. is likely to continue to run an income surplus vis-à-vis the rest of the world. So What? When it comes to the FX space, long-term valuations only become binding constraints when they are in the extreme. Right now, there is enough conflicting evidence to suggest that if the dollar is indeed expensive, it is not expensive enough to flash a bright sell signal. In this case, the U.S. dollar's dynamics are likely to be dominated by interest rate differentials. Interest rate curves outside of the U.S. seem currently fairly priced, but this is not the case in the U.S. Thus, with only two full hikes priced in over the next 24 months, one needs to see upside for U.S. interest rates if one is to be bullish on the greenback. Despite last month's very poor employment numbers, a consequence of hurricanes Harvey and Irma, the labor market remains strong enough to justify the Federal Reserve's desire to hike rates. The ISM surveys also remains very strong, with the headline numbers and new order components pointing toward robust growth. The only factor that could impede the Fed is inflation. On this front, we remain optimistic that inflation will not deteriorate much further and that, in fact, it is likely to pick up over the next six months, giving the Fed a green light to increase rates in line with its own forecast: First, in the past, we have highlighted that velocity of money - based on the money of zero maturity and nominal GDP - has been a very reliable leading indicator of inflation over the past 20 years, and is pointing toward a rebound in core inflation measures toward year-end.1 Moreover, the easing in U.S. financial conditions over the past 18 months also points toward upside risks to both U.S. growth and inflation. Second, the strength in the Prices-Paid component of both ISM surveys further increases our optimism. Moreover, the recent vigor of the Supplier Delivery subcomponent - a measure of bottlenecks in the system - also points to pipeline inflationary pressures. It is true that some of the recent spike is most likely skewed by the devastating impact of the hurricanes, but this improving trend began much earlier this year. Historically, a combined improvement in both the Prices-Paid and the Supplier Delivery components of the ISM survey tends to provide long leads on core inflation (Chart I-9). Third, the New York Fed has recently started publishing an underlying inflation trend estimate. This measure has also been rebounding sharply, hitting its highest level in 10 years, also pointing toward higher core inflation (Chart I-10). Chart I-9Pipeline Inflationary Pressures##br## Are Growing In The U.S. Chart I-10Underlying Inflationary ##br##Pressures Are Growing Fourth, the behavior of inflation itself is somewhat encouraging. While the recent core PCE year-over-year numbers have been disheartening, the three-month annualized rate of change has picked up robustly. Historically, this has also led to turning points in the year-on-year number (Chart I-11). Finally, there are signs of underlying vigor in wages. Last week's U.S. average hourly earnings number clicked in at 2.9%.It was likely overinflated by the effect of the hurricanes, which have temporarily dropped workers in low-paid industries out of the sample used by the U.S. Bureau of Labor Statistics to compute this data. However, the median average hourly earnings across the key sectors covered by the BLS has been in an uptrend since the beginning of the year (Chart I-12), pointing to some faint but real early signs of rising underlying wage growth. Moreover, while much ink has been spilled regarding whether or not the Philips curve is flat, there remain a well-defined tight relationship between the U.S. employment cost index (ECI) and the level of employment-to-population ratio in the U.S. (Chart I-13). Our view that employment growth will likely continue to tick in north of 120,000 jobs for the next 12 months, implies further improvement in the employment-to-population ratio, and thus a growing ECI. This will both support household income and consumption as well as our inflation view. Chart I-11Sequential Inflation Pointing ##br##To A Turning Point Chart I-12Cross-Sectional Median ##br##Of Wages Improving Chart I-13The Cross-Sectional Median##br## Of Wages Improving Bottom Line: With no clear message from long-term valuation, the key driver of the dollar is likely to remain interest rate differentials. At this point, U.S. interest rates need U.S. inflation to be able to rise by more than what is implied in the OIS curve and lift the dollar. Signs continue to accumulate that U.S. inflation is likely to turn the corner over the next six months, thanks to an easing in U.S. financial conditions and the pick-up in the velocity of money: the Prices-Paid and Supplier Deliveries components of the ISM have hooked up significantly, the NY Fed's underlying inflation measure is strong, the sequential growth rate in core inflation is improving, and there are growing signs that wage growth in the U.S. is picking up. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Fade North Korea, And Sell The Yen", dated August 11, 2017, or Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades