Economic Growth
Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Growth Scare: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Feature Just like that other great October tradition, Halloween, market volatility has returned to spook investors. Both the MSCI All-Country World Index and S&P 500 index are officially in correction territory, down -10% from the highs reached in September. The causes for the pullback range from high-profile third quarter U.S. earnings disappointments to increased evidence that the U.S.-China tariff war is negatively impacting U.S. investment spending. Yet the reaction from global bond markets has been relatively muted for such a large pullback in stocks. Benchmark 10-year government bond yields for the major developed markets are down from their peaks, but the declines have been smaller in countries where central banks are in a rate hiking cycle (U.S. -14bps, Canada -19bps) relative to countries where central banks are on hold (Germany -20bps, U.K. -31bps). One possible reason for this discrepancy is that the downtrend in data surprises appears to have stabilized in the U.S. and, even more importantly, China, while European data continues to disappoint relative to expectations (Chart of the Week). Chart of the WeekNoisy Equities, Calm Bonds We still do not believe that global bond yields have peaked for the cycle. We continue to recommend a below-benchmark strategic bias on overall duration exposure, but with only a neutral allocation to global corporate bonds that favors U.S. credit. On a more shorter-term tactical basis, there is a risk that yields could decline further, with more credit spread widening than seen during the current risk-off episode, if economic data starts to disappoint in the U.S. where growth has so far been resilient. Staying up in credit quality within an allocation to U.S. corporates is one way to hedge against such an outcome. Bond Yields Are Normalizing, Bond Volatility Is Not The selloff in risk assets has resulted in a pickup in widely-followed market volatility measures like the U.S. VIX index. Yet when looking at the level of realized total return volatility across all major asset classes, the current bout of turbulence has been unimpressive outside of global equities. In Chart 2, we present an update of a chart from our 2018 global bond outlook report, showing the current levels of realized volatility across different asset class benchmarks compared to their historical ranges. The vertical lines in each chart represent the range between 1999 and 2017 of annualized monthly volatilities for global government bonds, credit, equities, currencies and commodities. The red triangles represent the most recent 13-week annualized volatilities for those same asset classes. What stands out in the chart is that volatilities are off the historical lows for global equities, Italian government bonds and industrial commodities, yet volatilities remain subdued for developed market government bonds, global corporate debt and currencies. Chart 2Bond Volatility Remains Subdued, Despite More Volatile Equities We have long argued that the shift to a structurally higher level of volatility across all asset classes will show up first with a rise in bond volatility. In the U.S., in particular, sustained periods of elevated volatility for both Treasuries (as measured by the MOVE index) and stocks (as measured by the VIX index) have occurred alongside episodes of greater variance in nominal GDP growth (Chart 3). When the latter rises, that also triggers more uncertainty about the future path of monetary policy which feeds into a rise in expected bond volatility. That, in turn, impacts volatility in growth sensitive assets like equities, credit and commodities. Chart 3Equity Vol Responding To Growth Uncertainty Right now, nominal GDP volatility has picked up in the U.S. but still remains low by historical standards (middle panel). Some of that increased growth volatility can be attributed to the Trump fiscal stimulus coming at a time of full employment, which has helped boost both real GDP growth and U.S. inflation. Interest rate markets have moved to discount more Fed hikes in response, but the Fed's steady pace of well-telegraphed, 25bps-per-quarter rate increases is likely acting to dampen Treasury market volatility. As we have written about extensively throughout the course of 2018, the hurdle for central banks (not just the Fed) to shift to a less hawkish or more dovish policy stance is much higher when unemployment is low and inflation is closer to central bank targets. In such an environment, the correlation between equity and bond returns should be weaker than during periods of excess capacity and low inflation when central banks can stay dovish. That can be seen in Chart 4, which plots the trailing 52-week correlation of total returns for equities and government bonds for the major developed markets (top panel), along with the 10-year market-based inflation expectations for each country (bottom panel). For almost all countries shown, the stock/bond correlation has risen to zero away from the negative correlations that dominated the post-crisis years. That move in correlations has occurred alongside a more stable backdrop for inflation expectations, which are much closer to central bank targets. The lone exception is, of course, Japan, where inflation remains disappointingly low and the Bank of Japan continues to keep a tight lid on interest rates. Chart 4More Stable Inflation Means Less Correlated Stock & Bond Returns Besides more stable inflation, another factor preventing yields from falling as much as implied by the declines in equity markets is that global bond yields remain overvalued relative to trend economic growth. One way to assess this is to look at the level of real bond yields relative to a moving average of actual GDP growth. We show this for the major developed economies in Charts 5 & 6, which plot rolling 3-year moving averages of real GDP growth (a proxy for "trend" or potential growth) versus real 5-year government bond yields, 5-years forward. For the latter, we take the nominal 5-year/5-year forward yield and subtract a five-year moving average of realized headline inflation for each country, rather than market-based inflation-linked instruments like CPI swaps or TIPS, to allow for a longer history of real yields in the charts. Chart 5Real Bond Yields Are Still Too Low ... Chart 6... Compared To Real Economic Growth For all countries show, real bond yields remain below the level of real growth. The gap between the two is smallest in the U.S. and Canada - unsurprising, as central bankers have been tightening monetary policy, and helping push up real interest rates, in both countries. Bonds look most overvalued in core Europe, Japan and Sweden where policymakers have been using negative interest rates and quantitative easing (QE) to hold down bond yields. Real yields in those countries are between 200-300bps below our proxy for trend real growth. With such a large gap between actual growth and interest rates, it becomes harder for policymakers to consider easing monetary policy, or at least slow the pace of policy normalization, in response to more volatile financial markets. It should not be a surprise that last week, during a period of global market turmoil, the European Central Bank and Sweden's Riksbank both signaled that they remain on pace to end QE and begin hiking interest rates within the next 6-12 months, while the Bank of Canada delivered another 25bp rate hike. In the absence of a VERY large global growth shock, global real yields should be expected to increase over at least the next year, and a defensive posture on global duration exposure should be maintained. One such shock could come from a deeper downturn in China than has already occurred in 2018, which would feed into a bigger slowdown in non-U.S. growth. Another shock could come from the U.S. if the recent pullback in core durable goods orders (Chart 7) is a sign that a) U.S. companies are becoming more worried about the impact of U.S.-China trade tariffs on global growth; and/or b) the impact of the Trump fiscal stimulus is already starting to fade. Such a move could be exacerbated by a larger downturn in housing activity than seen already in response to rising mortgage rates. Chart 7Treasuries Are Exposed To A U.S. Growth Scare These shocks, if large enough, could trigger a short-covering rally in U.S. Treasuries, where sentiment remains very depressed (bottom panel). However, with leading economic indicators still pointing to above trend U.S. growth, and with U.S. consumer spending holding firm alongside a tight labor market and faster wage growth, such a pullback in yields would likely be short-lived and difficult for investors to time successfully. Bottom Line: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada Update: The BoC Stays Hawkish The Bank of Canada (BoC) delivered another rate hike last week, lifting the policy rate by 25bps to 1.75%. The language used to explain the hike was surprisingly hawkish. In the press conference following the BoC meeting, Senior Deputy Governor Carolyn Wilkins noted that the policy rate remains negative in real terms and is still below the central bank's estimate of neutral (between 2.5% and 3.5%). She also noted that the term "gradual" was no longer used to describe the pace of monetary tightening, so as not to give the impression that policy was following a steady predetermined path similar to the Fed's tightening cycle - potentially, a sign that more hawkish surprises could be in the offing. The BoC also sounded more optimistic on the outlook for the Canadian economy, while sounding less concerned about the two factors that should cause the most worry - high consumer debt levels and uncertainty over global trade. The more upbeat tone is at odds with the current pace of economic growth in Canada, which has slowed. GDP growth has decelerated to 1.9% from 3.0% at the end of 2017, while the OECD's leading economic indicator for Canada is also in a downtrend (Chart 8). In the Monetary Policy Report (MPR) that was also released last week, the latest BoC forecasts for Canadian real GDP growth for 2019 and 2020 were essentially left unchanged. Chart 8Is The BoC's Growth Optimism Justified? The BoC noted that the composition of demand within the Canadian economy was shifting away from consumption and housing towards business investment and exports. That can be seen in the most recent data that shows sluggish consumer spending (middle panel) and rebounding export growth (bottom panel). The central bank attributes the softer path for consumption to its own interest rate increases and changes to housing market policies, both of which have forced households to adjust their spending patterns. That is evident in the sharp decline in house price growth, deceleration of household credit growth and the softening trends in housing starts and residential investment spending (Chart 9) Chart 9Canadian Housing Has Cooled Off The BoC is of the view, however, that consumer spending will rebound (but not overheat) on the back of strong household income growth and a pickup in net immigration inflows that is boosting population growth. The other area of diminished concern for the central bank is investment spending, which has been negatively impacted by the uncertainty over the renegotiation of the North America Free Trade Agreement (NAFTA). That smooth acronym is now gone, to be replaced by the more awkward "USMCA", or United States-Mexico-Canada Agreement. That new trade deal has reduced the immediate uncertainty over the impact of U.S. trade policy on Canada, although the BoC did note in the MPR that there was still the potential for lingering uncertainty based on previous U.S. trade actions (i.e. on steel and aluminum imports to the U.S.) and because the USMCA has not yet been ratified. The BoC did make an upward adjustment to its assumptions regarding the hit to Canadian growth from U.S. trade policy compared to the July MPR. The level of exports is now only expected to fall by -0.3% over the next two years (vs -0.7% in the July MPR) and business investment is expected to decline by -0.7% over the same period (vs -1.4% in the July MPR). The reduction in trade uncertainty should be expected to free up demand for capex in Canada. The Q3/2018 BoC Senior Loan Officers' Survey reported a further easing of lending standards from the Q2 survey (Chart 10). The central bank's Q3 Business Outlook Survey also noted that firms' investment intentions continued to strengthen to the highest level in eight years (middle panel). This was primarily due to increased expectations for future sales growth, coming at a time of high reported capacity pressures (bottom panel). Importantly, the Business Outlook Survey took place before the USMCA deal was reached, suggesting that the data may actually understate sales expectations. This bodes well for future gains to overall GDP growth from business investment spending. Chart 10Canadian Companies Need To Invest & Hire That same Business Outlook Survey also reported that firms are continuing to experience labor shortages, most notably in sectors such as construction, transportation and information technology. This is a sign that employment growth should remain firm in Canada. Coming at a time when the unemployment rate at 5.9% remains well below estimates of full employment, this suggests that there could be some upward pressure on inflation. Canadian headline CPI inflation currently sits at 2.2%, while core CPI inflation is at 1.8% (Chart 11). That is a sharp decline from the 3% inflation seen in July, which was the result of an unexpected surge in airline fares. Yet at current levels, Canadian inflation sits right at the midpoint of the BoC's 1-3% target range. Furthermore, the BoC's own assessment is that the output gap is in a range of -0.5% to +0.5%, in line with the estimates from the IMF and OECD (middle panel). Although headline wage growth has cooled in recent months, the BoC's preferred measure that incorporates several wage measures ("Wage-Common"), has been stable near the same 2% levels as seen for CPI inflation. Chart 11Canadian Inflation At BoC Target Expect More BoC Hikes With the Canadian economy operating at full employment and with inflation at target, the BoC seems determined to push the policy rate back up towards their estimated 2.5%-3.5% range for the neutral rate. This means another 75-175bps of additional rate increases. At the moment, there are only 49bps of hikes over the next year discounted in the Canadian Overnight Index Swap (OIS) curve (Chart 12). This leaves Canadian bond yields exposed to additional rate increases. This is especially true given our forecast of continued Fed interest rate increases in 2019, as the BoC has been playing a game of "Follow the Leader" with the Fed during the current tightening cycle (top panel). Chart 12Stay Underweight Canadian Government Bonds In terms of our recommended fixed income investment strategy, we continue to favor: an underweight stance on Canadian government bonds for global bond investors a below-benchmark duration stance within dedicated Canadian bond portfolios long positions in Canadian inflation protection (CPI swaps or inflation-linked bonds) While we expect the Canadian yield curve to flatten as the BoC delivers more rate hikes than currently discounted over the next year, we do not see the 2-year/10-year curve flattening by more than is currently priced in the forwards. This is not the case for an outright duration bet, where the forwards are currently priced for very little upward movement in Canadian bond yields over the next year. Therefore, we prefer to stick with directional bets on Canadian yields (higher) and Canadian relative bond performance versus global peers (worse). Bottom Line: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The correction in global equities is not yet over, but we would turn more constructive if stocks retreated about 6% from current levels. Among the many things bothering investors, the fate of the Chinese economy remains high on the list. Chinese growth continues to slow, with the impact of the trade war yet to be fully felt. Investors are likely to end up being disappointed by both the size and the composition of Chinese stimulus. High debt levels and excess capacity limit the prospective benefits of traditional fiscal/credit easing. Stimulus measures aimed at boosting consumption, which is what the authorities are increasingly focusing on, would help the Chinese economy. However, they would generate only small gains for the rest of the world. A weaker yuan would be outright negative for other economies. Cyclically and structurally, we expect the bond bear market to continue, but slower Chinese growth and a stronger dollar could temporarily cap Treasury yields over the coming months. Feature Correction Slightly More Than Halfway Through We argued in our October 5th report that "prudent investors should consider scaling back risk if they are currently overweight risk assets" because the market was at an elevated risk of a "phase transition" from unbridled optimism to a more sober appreciation of the risks presently facing the global economy.1 The good news is that the ongoing correction will be just that, a correction. Both monetary and fiscal policy in the U.S. remain highly accommodative. The next recession will not occur until late-2020 at the earliest. U.S. equities, which account for over half of global stock market capitalization, rarely enter sustained bear markets outside of recessions (Chart 1). Chart 1Recessions And Bear Markets Usually Overlap The bad news is that we have yet to reach a capitulation point. As we noted last week, corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot.2 Normally, stocks need to break through prior support levels several times before "buy the dip" investors throw in the towel. This week saw the S&P 500 fall below its October 11th lows. A few more iterations of this pattern may be necessary. To repeat what we wrote before, barring any major new developments, we would turn bullish on global equities again if the MSCI All-Country World Index were to fall by 12% 10% 8% 6% from current levels. With that in mind, we are putting in a limit order to buy the ACWI ETF at $64.3 Emerging Markets: Time To Pay The Piper Even if we were to turn more positive on global equities, we would maintain our preference for developed market stocks over emerging markets, despite the latter's higher beta nature. The wave of liquidity created by the Fed and other major central banks over the past decade ended up flowing into places where it was not needed. Emerging markets were a prime destination: Dollar-denominated debt in emerging markets now stands at levels reached just before the late-1990s Asian Crisis (Chart 2). Chart 2EM Dollar Debt At Late-1990s Levels While EM valuations have cheapened considerably, they are not yet at washed out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Chinese Stimulus To The Rescue? China figures heavily into the equation. If the Chinese government were to deliver a massive dose of traditional fiscal/credit easing, this would boost fixed-asset investment and thus commodity prices, helping emerging markets in the process. Such a dollop of stimulus would also lift global growth. As a countercyclical currency, the U.S. dollar tends to weaken when global growth accelerates (Chart 3). The reflationary impulse from higher commodity prices and a softer dollar would be manna from heaven for emerging markets. Chart 3Decelerating Global Growth Tends To Be Bullish For The Dollar If we had strong confidence that such a burst of stimulus were forthcoming, we would be comfortable in calling the end of the global stock market correction now and going overweight EM assets. Unfortunately, the evidence so far suggests that while the Chinese authorities are stimulating the economy, they are not doing so by enough to reignite growth (Chart 4). Chart 4Chinese Growth Remains Soft Real GDP increased at a weaker-than-expected pace in the third quarter. Industrial production surprised on the downside in September, echoing declines in the manufacturing PMI. Home sales are running well below housing starts, suggesting downside risk for the latter in the months ahead. Goldman's China Current Activity Indicator has continued to grind lower, while the economic surprise index remains mired in negative territory. Our conversations with clients suggest that most are expecting the recently announced stimulus measures to arrest and then reverse the downward trend in growth. We are not so sure. As our geopolitical team has stressed, the Chinese government has expended a lot of political capital on its reform agenda.4 Abandoning it now would not only cause the government to lose credibility, but it would undermine the very reasons it was implemented in the first place. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart 5). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart 6). Our China team estimates that 15%-to-20% of apartments are sitting vacant.5 Chart 5China: Debt And Capital Accumulation Went Hand In Hand Chart 6Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Today, Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. As such, we are skeptical that the recent acceleration in credit growth will have long legs (Chart 7). Anecdotal evidence suggests that some companies which are receiving credit are simply holding on to the cash, rather than running the risk of being accused of investing in money-losing projects. Monetary policy in China is increasingly pushing on a string. Chart 7China: Only A Modest Acceleration In Credit Growth Rebalancing: Be Careful What You Wish For This does not mean that China will not try to prop up its economy. It will. But the form of stimulus the government pursues may not be to foreign investors' liking. For example, consider the recently announced income tax reforms, which raise the threshold at which households need to start paying taxes while increasing deductions for education, health, housing, and eldercare. In and of themselves, these measures are admirable and long overdue. The Chinese income tax system is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 8).6 A more progressive tax system would boost consumption among poorer households. Chart 8High Tax Burden For Low-Income Households In China The snag is that raw materials and capital goods comprise 85% of Chinese imports. As Arthur Budaghyan, BCA's Chief EM strategist, has long noted, policies that boost Chinese consumption are simply less beneficial to the rest of the world than policies that boost investment.7 Pundits who talk about the virtue of "rebalancing" the Chinese economy away from fixed-asset investment and towards consumer spending should be careful what they wish for! The Trade War Will Heat Up One of the more notable aspects of China's recent slowdown is that it has been concentrated in domestic demand rather than in net exports. Remarkably, Chinese exports to the U.S. actually increased by 12% in dollar terms in the first nine months of the year, compared to the same period in 2017. However, judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, the export sector is likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 9). Chart 9China: An Ominous Sign For Exports Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the G20 leaders' summit in Buenos Aires on November 29 are likely to be disappointed. As we have stressed in the past, Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It will also force the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a "big, beautiful" trade agreement with them (incidentally, the new USCAM USMCA agreement is remarkably similar to the "horrible" one that it replaced with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China). This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit. Reaching a deal with China would actually be a strategic mistake for Trump's political career. A Weaker RMB Ahead A weaker Chinese currency would blunt some of the pain inflicted on China's export sector from Trump's tariffs. There is obviously a limit to how far China can let its currency slide, but last week's decision by the U.S. Treasury to refrain from labeling China a currency manipulator will probably embolden the Chinese to allow the currency to depreciate some more from current levels.8 A weaker Chinese currency would be a cold shower for the rest of the world. Not only will it make other economies less competitive in global markets; it will also reduce Chinese imports. Concluding Thoughts Investors spend a lot of time debating the magnitude of China's stimulus plans and not enough time thinking about the composition of that stimulus. Credit/fiscal easing of the sort China has historically engaged in is good for other emerging markets because it sucks in raw materials and capital goods. In contrast, consumption-based stimulus is only modestly beneficial to the rest of the world, while a weaker Chinese currency is an outright negative for other economies. If China focuses more on the latter two types of stimulus and less on the former, global investors are likely to be disappointed. Emerging market assets have cheapened considerably over the past few months and will likely find a bottom in the first half of next year. For now, however, investors should overweight developed market stocks relative to their EM peers. Consistent with our July 5, 2016 call declaring "The End Of The 35-Year Bond Bull Market," both the cyclical and structural trend in bond yields is firmly to the upside. Tactically, however, bonds are deeply oversold (Chart 10). The combination of slower EM growth, disappointments over the magnitude and composition of Chinese stimulus, and a stronger dollar will put a lid on yields over the next few months. Chart 10Treasurys Are Oversold Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. 2 Please see Global Investment Strategy Weekly Report, "Phase Transitions In Financial Markets: Lessons For Today," dated October 19, 2018. 3 Valid during extended trading hours. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, "How Stimulating Is The Stimulus? Part Two," dated August 15, 2018. 5 Please see Emerging Market Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018. 6 Please see Global Investment Strategy Special Report, "Is China Heading For A Minsky Moment?" dated April 13, 2018. 7 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018. 8 Ironically, while China may not be manipulating its currency based on the Treasury's legal definition, economic logic suggests it is. True, China is no longer buying dollars in a bid to weaken the yuan. In fact, its reserves have actually declined significantly since 2015. However, the value of the yuan is determined not just by current dollar purchases; it is also determined by those that have taken place in the past. If a central bank buys dollars, this bids up the value of those dollars relative to its own currency. If it then stops buying dollars, its currency does not instantly fall back to its original level. All things equal, it just stays where it is. The best parallel is with quantitative easing. Both theory and evidence suggest that it is the stock of bonds that a central bank owns, rather than the flow of bonds in and out of its balance sheet, that determines the level of yields. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Duration: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Yield Curve: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Feature If investors were already worried about the impact of restrictive Fed policy on credit spreads and equities, the minutes from September's FOMC meeting - released last Wednesday - did nothing to calm their nerves. The minutes revealed that "a few participants expected that policy would need to become modestly restrictive for a time" while an additional "number" of participants "judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level." There is a small distinction between the "few" participants who expect that a fed funds rate above the estimated longer-run neutral level of 3% will be necessary because restrictive monetary policy will be warranted and the "number" of participants who think that the fed funds rate will move above 3% without policy turning restrictive. However, the main takeaway for investors should be that a large portion of the committee expects that rate hikes will continue until the fed funds rate is at least above 3%. In last week's report we explored the risk that higher yields lead to an excessive tightening of financial conditions and actually sow the seeds of their own decline.1 But we do not view that as the greatest threat to our recommended below-benchmark portfolio duration stance. The biggest risk to that view comes from the ongoing divergence between strong U.S. and weak foreign economic growth. No Contagion... Yet Chart 1 shows that, since 1993, every time our Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed. But while the Global (ex. U.S.) LEI has now been below zero for nine consecutive months, there is so far no evidence of contagion into the United States. The resilience of the U.S. economy probably explains why the September FOMC minutes only briefly mentioned the risk from weak foreign growth. Chart 1U.S. And Foreign Growth Continue To Diverge From the minutes:2 The divergence between domestic and foreign economic growth prospects and monetary policies was cited as presenting a downside risk because of the potential for further strengthening of the U.S. dollar... But: Participants generally agreed that risks to the outlook appeared roughly balanced. The concern is that, much like in the 2014-16 period, the divergence in growth between the U.S. and the rest of the world puts so much upward pressure on the dollar that it eventually drags U.S. growth and bond yields lower. But despite this year's 4.6% appreciation in the trade-weighted dollar, we have yet to see any impact on our Fed Monitor and Treasury yields remain in an uptrend (Chart 2). This suggests that we have not yet reached peak divergence between U.S. and foreign growth. Further divergence and dollar strength is necessary before the U.S. economy is negatively impacted. Chart 2More $ Strength Required The reason why the dollar's recent appreciation has not yet exerted a discernible impact on the U.S. economy might be because overall global GDP growth is on a more solid footing than it was in 2014-16 (Chart 3). The IMF forecasts that global GDP growth will be 3.7% in 2018 and 2019, compared to 3.5% in 2015. Meanwhile, the moderation in Eurozone growth represents a decline from lofty 2017 GDP growth of 2.4%. Even in emerging markets, where the global growth slowdown is most apparent, the IMF is still forecasting GDP growth of 4.7% for both 2018 and 2019, a far cry from the 4.3% seen in 2015 (Chart 3, bottom panel). Chart 3Global Growth Stronger Than 2014-16 Of course, IMF forecasts can always change, and they likely will be revised lower if current trends continue. However, the key point for bond investors is that the global economy is in much better shape than it was between 2014 and 2016. This means that non-U.S. growth needs to see further significant weakness before the uptrend in U.S. Treasury yields is threatened. Bottom Line: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Can Uncertainty Steepen The Yield Curve? The yield curve has steepened somewhat during the past few weeks, the result of much higher yields at the long-end of the curve and short-end yields that have been roughly unchanged. We think Fed communication has been an important catalyst for this curve action. Specifically, the Fed's deliberate attempt to introduce uncertainty around its estimates of the neutral fed funds rate.3 Bond investors are finally getting the message that the Fed's median forecast of a 3% longer-run fed funds rate is not written in stone. Depending on the economic outlook, the funds rate could peak for the cycle at a level that is well above or below 3%. Given the recent spate of strong U.S. economic data, the market is starting to discount a peak that is above 3%, no matter what median forecast appears in the Fed's dots. This raises the question of whether a further un-anchoring of long-dated yields could occur. Is it possible that the yield curve will continue to steepen, even with the Fed lifting short rates at a gradual pace of 25 basis points per quarter? Below, we review a few different macro drivers of the yield curve and conclude that neither a large steepening nor large flattening is likely during the next 6-12 months. Nominal GDP Growth One useful rule-of-thumb for when monetary policy turns restrictive is when the 10-year Treasury yield exceeds the rate of growth in nominal GDP. In the past, a 10-year yield above the rate of growth in nominal GDP has coincided with downward pressure on core inflation (Chart 4). With that in mind, we note that nominal GDP has grown by 5.44% during the past year, by 3.98% (annualized) during the past two years and by 3.85% (annualized) during the past three years. Chart 410-Year Yield & Nominal GDP We discount the recent 5.44% growth rate because it was largely fueled by fiscal thrust that will fade in the coming quarters. This leaves us with a recent trend of 3.85% - 4% in nominal GDP growth. Even with no further deterioration in growth as the cycle matures, this puts an approximate cap on how high long-dated yields can rise before policy becomes restrictive and the cycle starts to turn. With the 10-year Treasury yield already at 3.19%, it can rise by between 66 bps and 81 bps before it reaches that range. If that adjustment were to occur very quickly, then the yield curve would steepen sharply and then re-flatten as the Fed lifted rates to catch up with the long end. Alternatively, if that adjustment were to occur over a period of 6-9 months, with the Fed hiking at a pace of 25 bps per quarter, the slope of the yield curve would be roughly unchanged. Wage Growth While nominal GDP growth is useful for thinking about long-maturity yields, wage growth correlates quite strongly with the slope of the yield curve itself. Specifically, rapid wage gains tend to coincide with curve flattening, and vice-versa. In fact, a typical cyclical pattern is that first the yield curve flattens and then wage growth accelerates to catch up with the curve (Chart 5). It would be highly unusual for the yield curve to steepen significantly while wage growth is rising, which it finally appears to be doing. Chart 5Higher Wage Growth = Flatter Curve We cannot completely rule out the possibility that stronger productivity growth actually causes unit labor costs to decelerate even as "top line" wage pressures mount. Unit labor costs are essentially the ratio of wages (compensation per hour) to productivity (output-per-hour), and the bottom panel of Chart 5 shows that a deceleration in unit labor costs could cause the yield curve to steepen. However, we note that there is not much precedent for strong productivity growth overwhelming an acceleration in wages, causing unit labor costs to diverge from other wage measures. For example, even as productivity growth strengthened in the 1990s, unit labor costs continued to rise alongside other measures of wage growth. Inflation Expectations We have frequently noted that inflation expectations embedded in long-dated Treasury yields remain too low compared to levels that are consistent with inflation being well-anchored around the Fed's 2% target. It stands to reason that long-maturity TIPS breakeven inflation rates could steepen the yield curve as they adjust higher. However, the 10-year TIPS breakeven inflation rate is currently 2.11%, only slightly below the range of 2.3% to 2.5% that has historically been consistent with well-anchored inflation expectations (Chart 6). In other words, the upside in long-dated breakevens is now fairly limited. In contrast, the 2-year TIPS breakeven inflation rate stands at only 1.70%, still considerably below "well-anchored" levels (Chart 6, bottom panel). Chart 6More Upside In Short-Dated Breakevens Further, since the financial crisis, breakevens at both the short- and long-ends of the curve have been driven by trends in the actual inflation data (Chart 7). If it is rising realized inflation that has driven both the 2-year and 10-year TIPS breakeven inflation rates higher this cycle, and the 2-year rate is further away from target than the 10-year rate, then it stands to reason that inflation expectations are more likely to exert flattening pressure on the nominal yield curve than steepening pressure. Chart 7Realized Inflation Is Driving Expectations Rate Volatility & The Term Premium One final macro driver that could steepen the yield curve would be a spike in interest rate volatility and an increase in the term premium at the long-end of the curve. Our prior research has shown that implied interest rate volatility is linked to uncertainty about the macro environment, and Chart 8 shows that the MOVE index of implied interest rate volatility has tended to track the dispersion of individual forecasts of 3-month T-bill rates and GDP growth. In this context, it should not be surprising that implied volatility fell to very low levels when interest rates were pinned at zero and not expected to move for an extended period. Chart 8Macro Uncertainty & Rate Volatility But, as was mentioned above, the Fed has been trying scale back its forward guidance and inject some uncertainty into the market. Indeed, we think this is one reason why the yield curve steepened and rate volatility increased during the past few weeks. Taking a broader view, we also observe that, historically, macro uncertainty and implied interest rate volatility have tended to fall when the Fed is hiking rates, only spiking once monetary policy becomes restrictive and the economic recovery is threatened. The yield curve is typically inverted by that point. This leaves us to conclude that some further increase in interest rate volatility from exceptionally low levels is possible, but a large spike is unlikely until monetary policy becomes restrictive. Investment Implications A survey of the macro drivers of the yield curve leaves us to conclude that the most likely outcome for the next 6-12 months is that the slope of the curve remains close to its current level, meaning that the curve undergoes a roughly parallel upward shift as the Fed continues to lift rates. However, if nominal GDP growth fails to decelerate from its current 5.44% clip, it is possible that the yield curve steepens first and then flattens as the Fed lifts rates more quickly to catch up. This is not the most likely outcome, but rather a risk to our base case scenario. The final piece of the puzzle is the observation that curve steepener trades continue to look attractively priced. Our current recommendation is to favor the 7-year bullet over a duration-matched barbell consisting of the 1-year and 20-year notes. This trade offers a spread of +8 bps above the reading from our fair value model (Chart 9). Or alternatively, our model shows that the 1/7/20 butterfly spread is currently priced for 29 bps of 1/20 curve flattening during the next six months (Chart 9, bottom panel). Chart 9Curve Steepeners Are Still Attractive That much curve flattening is highly unlikely in the current macro environment, and we continue to recommend curve steepener trades to profit from an unchanged yield curve during the next six months. Bottom Line: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1Please see U.S. Bond Strategy Weekly Report, "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 2https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180926.pdf 3Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The Fed remains on a tightening course as the U.S. economy has no spare capacity, yet growth in the rest of the world is suffering as EM financial conditions are tightening. It will take more pain for the Fed to capitulate and pause its 25-basis-points-per-quarter hiking campaign. This clash will heighten currency volatility and, as a result, carry trades will suffer. This means the current rebound in EM currencies is to be sold, and the dollar has more upside. China has not been deemed a currency manipulator, hence the RMB could fall more, creating a deflationary shock for the world. Keep an eye on what might become rocky U.S.-EU trade negotiations. Short CAD/NOK. Short GBP/NZD. Feature A significant increase in volatility across markets has been the defining characteristic of the past two weeks. This tumultuous environment is likely to persist as the Federal Reserve is set to tighten policy, and EM financial conditions deteriorate further. While it is true that enough market turbulence could cause the Fed to blink and temporarily pause its tightening cycle, the U.S. central bank has yet to hit this pain threshold. As a result, we expect carry trades and EM currencies to suffer further, even as we established a few hedges last week. The Battle Between The Fed And Global Growth Has Just Begun The Fed is set to increase interest rates further. For now there is little reason for the institution that sets the global risk-free rate to deviate from its current trajectory of increasing interest rates by 25 basis points per quarter. First, capacity utilization in the U.S. keeps increasing, and in fact, the amount of spare capacity in the U.S. economy is at its lowest level since 1989. This kind of capacity pressure has historically been enough to prompt the Fed to keep increasing rates, as it points toward growing inflationary risks (Chart I-1). Chart I-1No Spare Capacity In The U.S. Second, the labor market is currently at full capacity. This week's release of the JOLTS data not only highlighted that U.S. job openings continue to rise and are now well above the number of unemployed workers, but it also showed that the voluntary quit rate is at a 17-year high. U.S. workers are no longer petrified by fear of not finding a job if they were to jettison their current one. This is symptomatic of an economy running beyond full employment. Additionally, as Chart I-2 illustrates, the number of states where the unemployment rate stands below levels consistent with full employment is near a record high. Historically, this indicator has explained the Fed's policy well. Chart I-2The Labor Market And The Fed Third, and obviously a consequence of the previous two points, various components of the ISM survey are pointing toward an acceleration in U.S. core inflation (Chart I-3). This highlights that with the U.S. at full employment, the rise in inflation is giving free reign to the Fed to further lift interest rates. This development explains why Federal Open Market Committee members are much more willing than previously to display hawkish colors. Chart I-3U.S. Inflation Is In An Uptrend The problem for the currency market is that this hawkish Fed is not emerging in a vacuum. Global growth has begun to slow, and in fact is set to slow more. Korean export growth has been decelerating sharply, which historically has been a harbinger for global profit growth and global industrial production (Chart I-4). Chart I-4U.S. Strength Does Not Equate To Global Strength What lies behind this growth slowdown? In our view, two key shocks explain this vulnerability. First, China is deleveraging. Chart I-5 shows that efforts to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening imposed by Beijing, smaller financial institutions are not building up their working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak. The chart does highlight that deleveraging could take a breather in the coming months, in keeping with the change in official rhetoric. However, this pause is likely to be temporary. Do not expect China to push enough stimulus in its economy to cause a sharp rebound in indebtedness and capex. Xi Jinping has not yet abandoned his shadow bank crackdown, which weighs on overall credit expansion. Chart I-5Chinese Policy Tightening In Action Chinese Deleveraging Is Still Worth Monitoring Second, EM liquidity is deteriorating. Chart I-6 illustrates that global reserves growth has moved into negative territory. Historically, this indicates that our EM Financial Conditions Index (FCI) will continue to tighten. Many factors lie behind this deterioration in the EM FCI, among them: the collapse in performance of carry trades;1 the increase in the dollar and in U.S. interest rates that is causing the cost of servicing foreign currency debt to rise; and EM central banks fighting against currency outflows. Chart I-6Global Liquidity Is Tightening, So Are EM FCI This tightening in the EM FCI has important implications for global growth. As Chart I-7 shows, a tightening EM FCI is associated with a slowdown in BCA's Global Nowcast of industrial activity. As such, the tightening in EM financial conditions suggests that global industrial production can slow further. Since intermediate goods constitute 44% of global trade, this also implies that global exports growth could suffer more in the coming quarters. As a result, Europe, Japan and commodity producers remain at risk. The same can be said of EM Asia, which is the corner of the global economy most levered to global trade and global manufacturing. In fact, our Emerging Markets Strategy colleagues are currently reducing their allocation to Asia within EM portfolios.2 Chart I-7Tighter EM Financial Conditions Equal Lower Growth This deterioration in global growth and global trade is deflationary for the global economy. It is also deflationary for the U.S. economy. As we have highlighted in the past, since the U.S. economy is less levered to global trade and global IP than the rest of the world, weakening global growth tends to lift the greenback. Thus, if global goods prices are declining, such a shock can be compounded in the U.S. by a rising dollar. Does this mean the Fed will be forced to stop hiking rates in response to the growing turmoil engulfing the global economy and global financial markets? The Fed feedback loop suggests that if the dollar rises enough, if U.S. spreads widen enough, and if deflationary pressures build enough in response to these shocks, it will back off, as it did in 2016 (Chart I-8). Chart I-8The Fed Policy Loop However, the key question is that of the Fed's current pain threshold. We posit that 2018 is not 2016. As Ryan Swift argues in the most recent installment of BCA's U.S. Bond Strategy, the stronger the domestic economy is and the deeper domestic U.S. inflationary pressures are, the more the Fed will tolerate weaker global growth and tighter U.S. financial conditions.3 Currently, the U.S. domestic economy is so strong and so inflationary that despite less supportive U.S. financial conditions, our Fed Monitor still points toward more rate hikes in the coming quarters (Chart I-9). This is in sharp contrast to 2016, when the Fed Monitor highlighted the need for easier policy as U.S deflationary pressures were greater than inflationary ones. Chart I-9The BCA Fed Monitor 2018 Is Not 2016 As a result, we think that before the Fed blinks, the situation around the world will have to get worse. This means investors can expect further strength in the dollar and a further increase in borrowing costs around the world. Moreover, since the increase in U.S. bond yields is dominated by real rates, this means that the global cost of capital will continue its ascent - exactly as global growth is easing. This means financial markets could experience additional pain. In fact, Chart I-10 shows that the global shadow rate is a leading indicator of the currency market's volatility. Since the Fed is raising rates and the European Central Bank is tapering its asset purchases, the global shadow rate has scope to rise further. This points toward a continued increase in FX volatility. Higher FX volatility means that carry trades are likely to deteriorate again.4 If carry trades are to suffer more, this also implies that the current rebound in EM currencies is likely to prove temporary. Moreover, since an unwind in carry trades means that liquidity is leaving high interest rate countries, this also means that the EM FCI is set to tighten further, and global IP could suffer more. Chart I-10Higher Vol Ahead Hence, we recommend investors maintain a defensive stance in their FX exposure, favoring the dollar and the yen over the euro and commodity currencies. To be clear, we bought the NZD last week, but this position is a hedge. China is trying to manage the growth slowdown and is attempting to implement targeted stimulus measures. The risk is real that Beijing over-stimulates, which would cause the USD to weaken. The NZD is the best place to protect investors against this risk. Bottom Line: The Fed will continue to tighten policy as the U.S. economy is running well above capacity, creating domestic inflationary pressures. Meanwhile, EM economies are being hit by the combined assault of Chinese deleveraging and tightening financial conditions. This means the Fed is hiking in an environment of sagging global growth. Since it will take more pain for the Fed to back off, the dollar will rise further and carry trades will bear the brunt of the pain as FX volatility will pick up more. Use any rebound in EM currencies to sell them. Do the same with commodity currencies; AUD/JPY has further downside ahead. Breathe A Sigh Of Relief: China Is Not A Currency Manipulator On Wednesday, the U.S. Treasury published its bi-annual Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States report, better known in the market as the "Currency Manipulator Report." Despite the White House's vociferous pronouncements, the Treasury declined to name China a currency manipulator. This does not mean that it will not in the future, but it does mean that China may be willing to let the RMB weaken a bit further in the coming months to alleviate the pain of the trade war with the U.S. After all, a simple way to nullify the impact of tariffs is to let your currency fall. If Washington is not willing to take up this year's depreciation as a pretext for additional tariffs, then Beijing could just let the markets do its bidding and let the RMB weaken. This is dangerous for the global economy and for commodity prices. A weaker RMB means that the purchasing power of Chinese buyers in international markets will decline. This also means that the volume of Chinese purchases of industrial commodities could suffer. As a result, we continue to recommend investors minimize their exposure to the AUD. Moreover, a weaker RMB could cause fears of competitive devaluation across Asia, which means the Asian currency complex remains at risk. The most interesting piece of news from the report was that China only meets one of the three criteria that must be met to be deemed a currency manipulator: a bilateral trade surplus with the U.S. greater than US$20 billion. The Chinese aggregate current account surplus is well below the 3% of GDP threshold used by the U.S. Treasury, and the Chinese monetary authorities are not intervening in a single direction to depress their currency. But as Table I-1 shows, Japan, Germany and Korea already meet two of the Treasury's three criteria, and are thus ostensibly at an even greater risk of being named currency manipulators than China. However, the U.S. has already concluded a new trade deal with Korea that contains a currency component, and is seeking to do the same with Japan. Table I-1Where Does China Stand On The Treasury's Grid? It is true that naming China a currency manipulator will ultimately be a political decision, and on this front, the outlook is not good for China due to the structural decline in U.S.-China relations. But a chat with Matt Gertken of our Geopolitical Strategy Service reminded us that the EU and the U.S. are beginning to negotiate a trade deal, and Germany's large trade surplus could easily become a target. The U.S. and EU did not conclude the TTIP trade deal, so there is no foundation for the upcoming negotiations as there was with Korea, Canada, and Mexico. This raises the risk that the negotiations could be difficult and that the White House could threaten to implement tariffs against Germany under section 232 of the Trade Expansion Act of 1962 as a lever during the negotiations to get a more favorable deal for the U.S. This also means that heated trade negotiations between Europe and the U.S. could become a source of headline risk in the coming months, especially in the New Year - something the market does not need. Ultimately the U.S.'s main beef is with China and the Trump administration will want Europe's assistance in that quarrel. But Trump may still believe he can use tough tactics with the EU along the way. Bottom Line: China is not a currency manipulator. China could use this lack of designation as an opportunity to let the RMB weaken a bit further in the coming months. Moreover, Germany's large trade surpluses and the impending U.S.-EU trade negotiations suggest that the White House could use the lever of tariffs under section 232. This means that the risk of U.S.-EU trade-war headlines hitting the wire in the winter will be meaningful, though not as consequential as the U.S.-China conflict. This will contribute to higher volatility in the FX market. Sell CAD/NOK A potentially profitable opportunity to sell CAD/NOK has emerged. To begin with, CAD/NOK is an expensive cross, trading 10% above its purchasing-power-parity equilibrium (Chart I-11). While valuations are rarely a good timing tool in the FX markets, the technical picture is also interesting as the Loonie is losing its upward momentum against the Nokkie (Chart I-12). Chart I-11CAD/NOK Is Expensive Chart I-12From A Technical Perspective, CAD/NOK Is Vulnerable Economics point to a favorable picture as well. Now that the Norges Bank has joined the Bank of Canada in increasing rates, peak policy divergence is over. When policy divergences were at their apex, CAD/NOK was not able to break out. With Norway's current account standing at 6.6% of GDP versus -3% for Canada, without the help of policy, the CAD is likely to lose an important support versus the NOK. Moreover, there is scope for upgrading interest rate expectations in Norway relative to Canada. As Chart I-13 illustrates, the Canadian credit impulse has fallen relative to that of Norway, and Canada's employment growth is contracting when compared to the Nordic oil producer. This helps explain why Canadian PMIs are near record lows vis-Ã -vis Norway's, and why Canadian relative LEIs are also plunging to levels only recorded twice over the past 20 years. Chart I-13Canada's Economy Is Underperforming Norway's Additionally, CAD/NOK has historically tracked the performance of both exports and retail sales growth in Canada relative to Norway. Both these indicators have sharply diverged from CAD/NOK, and they suggest this cross could experience significant downside over the coming quarters (Chart I-14). This also further reinforces the idea that the Norwegian output gap may now be closing fast, especially relative to Canada. Chart I-14Economic Indicators Point To CAD/NOK Weaknesses In fact, Norwegian core inflation has also gathered steam, rising at a 2.2% rate, in line with Canada's. Meanwhile, Norwegian house prices are proving sturdier than Canadian real estate prices. This combination of similar inflation, improving growth, and outperforming dwelling prices suggests there is scope for investors to upgrade their assessment of the Norges Bank's policy versus that of the BoC. Finally, CAD/NOK is often affected by the spread between the Canadian Oil Benchmark and Brent (Chart I-15). Currently, the WCS/Brent spread is at a record low and may well rebound a bit. However, BCA's Commodity & Energy Strategy service expects Brent prices to rise to US$95/bbl in 2019, with a significant right-tail risk due to supply-curtailment.5 As the bottom panel of Chart I-15 illustrates, the WCS/Brent spread is inversely correlated to aggregate oil prices. Thus, higher Brent prices, especially if caused by supply disruptions, could lead to a continued large discount in the Canadian oil benchmark, and therefore downside risk to CAD/NOK. Chart I-15CAD/NOK Likes Weak Oil Prices This trade is not without risks. CAD/NOK is often positively correlated to the DXY dollar index. This means that this trade is at odds with our USD view. However, in the past five years, CAD/NOK and the DXY have diverged for more than two months more than 10 times. The current domestic fundamentals in Canada relative to Norway suggest that a low-correlation period is likely to emerge. Bottom Line: CAD/NOK is an attractive short. It is expensive and losing momentum exactly as the Canadian economy is falling behind Norway's. As such, investors are likely to upgrade their expectations for the Norges Bank relative to the BoC. This should weigh on CAD/NOK. No Brexit Risk Compensation In GBP; Sell GBP/NZD Six weeks ago, we published a Special Report arguing that while the pound was cheap on a long-term basis, its affordability mostly reflected the expensiveness of the greenback and that actually there was no risk premium embedded in the GBP to compensate investors for Brexit-related uncertainty.6 We argued that because there was a large stock of short bets on the GBP, the pound could rebound on a tactical basis but that such a rebound was likely to prove short-lived as there remained many political hurdles to pass before Brexit uncertainty abated. We thus expected GBP volatility to pick up. Now that the pound has rebounded, where do we stand? The Brexit risk premium remains as absent as it was in early September (Chart I-16). It is also true that the probability of a no-deal Brexit has decreased, which means that long-term investors could benefit from beginning to overweight the pound in their portfolios. However, a political labyrinth remains in front of us, which suggests that GBP volatility is likely to remain elevated, and that the pound could even suffer some tactical downside. Chart I-16No Brexit Risk Premium In GBP We have decided to express this near-term bearish Sterling view by selling GBP/NZD as a way to avoid taking on more dollar risk. First, since November 2016, GBP/NZD has rallied by 20%. Today, long positioning in the pound relative to the Kiwi is toward the top end of the range that has prevailed since 2004 (Chart I-17). This suggests that long bets in the GBP versus the NZD have already been placed. Chart I-17Speculators Are Already Long GBP/NZD Second, the U.K. and New Zealand are two countries where the housing market heavily influences domestic activity. In fact, as Chart I-18 shows, GBP/NZD tends to broadly track U.K. relative to New Zealand house prices. Currently, British residential prices are sharply weakening relative to New Zealand. Previous instances where GBP/NZD strengthened while relative dwelling prices fell were followed by vicious falls in this cross. Chart I-18Relative House Prices Point To A Weaker GBP/NZD... Meanwhile, the U.K. LEI has fallen to its lowest level since 2008 relative to New Zealand's. Moreover, U.K. inflation seems to be rolling over while New Zealand's may be bottoming. This combination suggests that investors expecting more rate hikes from the Bank of England over the coming 12 months but nothing out of the Reserve Bank of New Zealand could be forced to adjust their expectations in a pound-bearish fashion. Finally, over the past four years, GBP/NZD has followed the performance of British relative to Kiwi equities with a roughly one-quarter lag. As Chart I-19 shows, this relationship suggests that GBP/NZD has downside over the remainder of the year. Chart I-19...And So Do Relative Stock Prices Bottom Line: The British pound may be an attractive long-term buy, but the number of political landmines in the Brexit process remains high over the coming four months. As a result, we anticipate volatility in the GBP to remain elevated. Moreover, GBP has had a very nice bull run over the past two months and is now vulnerable to a short-term pullback. In order to avoid taking on more dollar risk, we recommend investors capitalize on the pound's tactical downside by selling GBP/NZD, as economic dynamics point toward a higher kiwi versus the pound. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and the Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, both available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "EMs Are In A Bear Market" dated October 18, 2018, available at ems.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 to $95/bbl" dated September 20, 2018, available at ces.bcaresearch.com 6 Please see Foreign Exchange Strategy Special Report, titled "Assessing the Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The retail sales control group growth outperformed expectations, coming at 0.5%, while retail sales ex autos growth surprised to the downside, coming in at -0.1%. JOLTS job openings outperformed expectations, coming in at 7.136 million. Moreover, both continuing jobless claims and initial jobless claims surprised positively, coming in at 1.640 million and 210 thousand respectively. DXY has risen by roughly 0.6% this week. We continue to believe that the dollar has cyclical upside; as the fed will likely raise rates more than what is currently discounted by the market. Additionally, slowing global growth and positive momentum should also provide a boon for the dollar. Tactically, however, positioning remains stretched, which means that a short correction is likely. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Industrial production yearly growth outperformed expectations, coming in at 0.9%. Moreover, construction output yearly growth also surprised to the upside, coming in at 2.5%. However, core inflation surprised negatively, coming in at 0.9%, while headline inflation was in line with expectations at 2.1%. EUR/USD has fallen by roughly 1% since last week. We expect the euro to have cyclical downside, given that it will be hard for the ECB to raise rates significantly in an environment where emerging markets are suffering. After all, Europe's economy is highly dependent on exports, which means that any hiccup in EM growth reverberates strongly on European inflation dynamics. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Capacity Utilization outperformed expectations, coming in at s positive 2.2%. It also increased relative to last month's reading. Moreover, industrial production yearly growth also surprised positively, coming in at 0.2%. Finally, the Tertiary Industry Index month-on-month growth also surprised to the upside, coming in at 0.5%. USD/JPY has been flat this week. We are neutral on USD/JPY on a cyclical basis, given that the tailwinds of rising rate differentials between U.S. and Japan will likely be counteracted by increased volatility, a positive factor for the yen. Investors who wish to hedge their short exposure to Treasurys can do so by shorting EUR/JPY, given that this cross is positively correlated to U.S. bond yields. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The yearly growth of average earnings including and excluding bonus outperformed expectations, coming in at 2.7% and 3.1% respectively. However, the claimant count change surprised negatively, coming in at 18.5 thousand. Finally, while the core inflation number of 1.9% outperformed expectations slightly, headline inflation underperformed substantially, coming in at 2.4%. GBP/USD has decreased by roughly 1.5% this week. Overall, we are bearish on the pound in the short-term, given that there is very little geopolitical risk price into this currency at the moment. This means that GBP will be very sensitive to any flare up in Brexit negotiations. We look to bet on renewed Brexit tensions by shorting GBP/NZD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The change in employment underperformed expectations, coming in at 5.6 thousand. Moreover, the participation rate also surprised to the downside, coming in at 65.4%. This measure also decreased from last month's number. However, the unemployment rate surprised positively, coming in at 5% and decreasing from the august reading of 5.3%; the labor underutilization measure tracked by the RBA also fell. AUD/USD has been flat this week. Overall, we continue to be bearish on the aussie, as the deleveraging campaign in China will be felt most strongly on China's industrial sector; a sector to which the Australian economy is highly levered, given that its main export is iron ore. Moreover, raising rates in the U.S. will continue to create an environment of volatility, hurting high beta plays like the AUD. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has risen by 0.4% this week. Last week, we bought the kiwi, as a hedge against dollar weakness. While the dollar has gained strength against most other currencies, the NZD has actually appreciated. We are also shorting GBP/NZD this week. This cross has broadly followed relative house price dynamics between U.K. and New Zealand, and the continued relative outperformance of kiwi housing points towards further weakening in GBP/NZD. Moreover, long positioning on this cross remains very high by historical standards, which means that there can significant downside for this cross on a 3 month basis. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has risen by roughly 0.5% this week. This week we are shorting CAD/NOK. This cross is expensive according to our PPP valuations. Moreover, the economic picture is also favorable for the NOK as the policy divergence between Norway and Canada has likely reached its peak. The credit impulse and the growth in employment are both stronger in Norway, while Norway's core inflation is now in line with Canada's. This means that rates in Norway have further upside, given that Canada's hiking cycle is much more advanced than Norway's. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Producer price inflation underperformed expectations, coming in at 2.6%. Moreover, the trade balance also surprised to the downside, coming in at CHF 2.434 million. EUR/CHF has fallen by 0.7% this week, as the EU leaders have expressed their displeasure towards Italy's new fiscal plan. On a structural basis, we continue to be bearish on the franc, as inflationary pressures continue to be too weak in Switzerland for the SNB to move away from its ultra-dovish monetary policy. That being said, political risks in emanating from Europe could prove to be bearish for this cross on a tactical basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by roughly 0.7% this week. The Norwegian krone is our favorite currency within the G10 commodity currencies. Norway is the only commodity currency with a substantial current account surplus. Furthermore, our commodity strategists expect oil to continue to strengthen, even though base metals might suffer in the face of Chinese monetary tightening. This relative outperformance by oil will help oil currencies outperform the NZD and the AUD. We are also shorting CAD/NOK this week, as Norway's economic strength is now matching Canada's. Thus, given that the Norges Bank has kept rates lower the BoC, there is room for rate differentials to move against CAD/NOK now that the Norwegian central bank has begun to lift its policy rate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by roughly 0.7% this week. We are bullish on the Swedish krona on a cyclical basis, as rates in Sweden are too low for the current inflationary backdrop. In our view, the Risksbank will have to make sure sooner rather than later that its monetary policy matches the country's economic reality. We are also bearish on EUR/SEK, as current real rate differentials points to weakness for this cross. Furthermore, easing by Chinese monetary authorities could provide further downside to EUR/SEK. After all the SEK is more sensitive to liquidity conditions than the EUR, which means that when liquidity is plentiful, EUR/SEK suffers. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Heightening geopolitical tensions between the U.S. and China, higher U.S. bond yields, tightening U.S. dollar liquidity and weakening EM/China growth - all combined - constitute a bitter cocktail for EM. Barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. U.S. banks are not creating new dollars sufficiently. In addition, they are shrinking their claims on EM. The U.S. dollar is primed for another upleg. Downgrade Indian stocks from overweight to underweight within a dedicated EM equity portfolio. Feature As China becomes more assertive and slightly hostile toward the U.S., this will likely mark a paradigm shift in the macro landscape and asset valuations and, hence, could become a grey swan1 event for emerging markets (EM). Investors remain complacent about the ongoing geopolitical confrontation between these two economic giants as well as other headwinds that China and EM are facing. The decision by the Trump administration to raise import tariffs to 25% on $200 billion of China's exports to the U.S. as of January 1, 2019 is an unambiguous signal that U.S. trade confrontation with China is not a pre-mid-term election political plot. Instead, it is the beginning of a long-term geopolitical battle between an existing and rising superpower. Remarkably, the just-concluded trade deal between the U.S., Mexico and Canada (USMCA) includes language that requires signatories to give notice if they plan to negotiate a free trade deal with a "non-market" economy.2 Provided "non-market" country is for now implied to be China, this corroborates that confrontation with the latter is a new long-term strategy for the U.S. In addition, investors should not expect China to be constantly on the defensive. Both the political leadership and people in China have realized that trade is not the only aspect where the U.S. is likely to challenge the Middle Kingdom, and they recognize it will be a long-term battle. Therefore, the communist party and President Xi will counter the U.S. with reasonably tough actions. Quite simply, failure to do so will place the political leadership's credibility in question. President Xi understands this well, and will not allow it to happen. It is hard to forecast the avenues and approaches that Chinese leadership will explore to confront the U.S. Yet the recent navy incident in the South China Sea exemplifies that China will not be silent in this row.3 More generally, EM financial markets are not ready for such negative surprises. For example, there has been little capitulation on the part of asset managers with respect to EM equities. In fact, they have lately been buying EM ETF futures (Chart I-1). Global financial market volatility calculated as an equally weighted average of volatility in U.S. and EM equities, U.S. bonds, various currencies, oil and gold are near its historic lows (Chart I-2). Chart I-1Asset Managers Have Been Buying EM Equity Futures Chart I-2Financial Markets Volatility Is Very Low Remarkably, the U.S. bond market volatility is at an all-time low while bond yields are breaking out (Chart I-3). Odds are the U.S. yields will move up considerably. The basis is that strong growth and rising inflation in the U.S. warrant considerably higher bond yields and more Fed rate hikes than are currently priced in. Barring a meaningful improvement in Chinese growth and global trade, higher U.S. bond yields will be overwhelming for EM financial markets. In particular, higher U.S interest rates could trigger another downleg in the value of Chinese yuan. Chart I-4 illustrates that the China-U.S. interest rate differential has been instrumental to moves in the RMB/USD exchange rate. Chart I-3A Breakout In U.S. Bond Yields Chart I-4China Vs. U.S.: Does Interest Rate ##br##Differential Explain Exchange Rate? Apart from the heightening geopolitical tensions between the U.S. and China and higher U.S. bond yields, weakening EM/China growth, tightening global U.S. dollar liquidity and a strong U.S. dollar all combined will constitute a bitter cocktail for EM. We discuss some of these negatives below. All in all, financial markets could be on the cusp of a volatility outbreak, and EM will still be at the epicenter of the storm. BCA's Emerging Markets Strategy service continues to recommend short positions in EM risk assets and an underweight allocation versus DM. A Dead Cat Bounce... Emerging markets share prices have attempted to stage a rebound lately, but so far it appears to be nothing more than a dead cat bounce. Even thought the aggregate EM equity index managed a 5% bounce in recent weeks, both the EM equally weighted equity and small-cap indexes have failed to rebound at all (Chart I-5, top and middle panels). Similarly, EM bank stocks - which make up 17% of the MSCI market cap and are the key to the benchmark's performance - have not rallied (Chart I-5, bottom panel). This is occurring at a time when the S&P 500 is at all-time highs. These are very unhealthy signs for EM risk assets. ...As China/EM Growth Continues To Downshift The premise behind the lack of meaningful rebound in EM equities in our view is that both global manufacturing and world trade growth continue to downshift (Chart I-6, top panel). The epicenters of the slowdown are China and other emerging economies (Chart I-6, middle and bottom panels). Chart I-5No Confirmation Of EM Rebound Chart I-6EM/China Growth Is Decelerating Importantly, the Markit PMI manufacturing surveys suggest export orders contracted in September in the world's important manufacturing hubs, including China, Japan, Taiwan and Germany. The last time such poor export performance was registered was more than two years ago. The slump in the aggregate EM manufacturing PMI explains not only the EM equity selloff but also EM credit spreads widening and EM currency depreciation since the beginning of this year (Chart I-7). So long as the weakening trend in EM/China and global trade growth persist, EM risk assets and currencies will continue to sell off. Regarding China, growth deceleration was already occurring before the initial import tariffs took hold. Specifically, not only are overseas orders weak, but also domestic orders have rolled over decisively, as indicated by the People's Bank of China's (PBoC) 5000 industrial enterprise survey (Chart I-8). Chart I-7Weakening Growth Explains Selloff In ##br##EM Credit And Currencies Chart I-8China: Domestic And Overseas Orders In the mainland, the boost to infrastructure spending in the coming months will likely be offset by a slump in property construction and other segments of the economy. We discussed this angle in our recent report,4 but in recent days there has been more real estate market tightening. Specifically, the authorities are considering the cancellation of the housing pre-sale system in Guangdong province - a policy that could be applied to other geographies. The motive of this tightening is to curb both the land-buying frenzy and Ponzi financing schemes that many developers are involved in. This fits the policy script of dealing with and purging speculation and excesses early to prevent a bust later. These policy measures will cut off property developers from their primary source of funding - presales - and force them to reduce their construction volumes. As an unintended consequence of this announcement, some developers have already begun cutting house prices to accelerate pre-sales and raise funds. Given already bubbly property valuations and the existence of substantial speculative buying, house price deflation could set off a domino chain effect of lower prices, reduced speculative investment purchases and financial strains on developers, leading them in turn to offer even larger price discounts to generate funds faster, and so on. Forecasting the exact trajectory of a downturn and the speed of its adjustment is impossible. This is why we focus on the presence of major imbalances/excesses and policy tightening that could cause disentangling of these excesses. Given the still-considerable property market excesses5 prevalent in China and the money/credit tightening that has already occurred in the past two years, we reckon the odds of a material property market downtrend are substantial. On the whole, our main theme for China and EM remains that mainland construction activity will continue to downshift, with negative implications for countries that supply construction goods, materials and equipment. U.S. Dollars Shortages? The U.S. economy is firing on all cylinders and inflationary pressures continue to rise. Barring a deflationary shock from China/EM, the Federal Reserve has little reason to halt its rate hikes or abandon its policy of shrinking its balance sheet. Not only are U.S. interest rates rising, but there are also budding U.S. dollar shortages that will get worse: The U.S. banking system's excess reserves at the Fed are dwindling, as the latter continues to shrink its balance sheet (Chart I-9). U.S. banks' dollar-denominated claims on foreign entities in general and emerging markets in particular are shrinking (Chart I-10). Thus, EM debtors in particular have found themselves short of dollars. Chart I-9The U.S. Dollar Is Primed For Another Upleg Chart I-10U.S. Dollar Shortages In Rest Of World Finally, U.S. banks are not creating enough dollars - their total assets are growing at a paltry rate of 1%, and U.S. broad money (M2) growth is expanding at 4% annually - the slowest pace in the past 14 years excluding the aftermath of the 2008 credit crisis (Chart I-11). Bottom Line: The Fed is shrinking its balance sheet, and high-powered money/liquidity in the banking system is falling. This and other factors are discouraging U.S. banks from creating new U.S. dollars. Along with rising U.S. interest rates, this will propel the greenback higher, which will be detrimental for EM risk assets. Equity Portfolio Rotation Amid High Oil Prices Given the recent breakout in oil prices, we make the following changes to our country equity allocation: Upgrade Russia from neutral to overweight.4 October 2018 Orthodox macro policy and high oil prices will help this bourse to outperform the EM benchmark (Chart I-12, top panel). We have already been overweight Russia within EM local bonds, currency and credit portfolios.6 Chart I-11U.S. Banks Are Not Creating Sufficient Amount Of Dollars Chart I-12Upgrade Russian And Colombian Equities ##br##From Neutral To Overweight Upgrade Colombian equities from neutral to overweight. Like Russia, high oil prices and orthodox macro policies justify an upgrade (Chart I-12, bottom panel). Upgrade Malaysia from underweight to neutral.4 October 2018 High energy prices, hope for structural changes and low inflation do not justify an underweight stance. Still, Malaysia is vulnerable to slowdown in global trade and credit excesses of the past years that have not yet been worked out. This prevents us from upgrading this bourse to overweight. Downgrade Philippines equities from neutral to underweight.4 October 2018 Inflation is breaking out and the central bank is behind the curve.7 Downgrade India from overweight to underweight. More detailed analysis on India starts on the following page. Our equity overweights are Taiwan, Korea, Thailand, Chile, Mexico, Colombia, Russia and central Europe. Our underweights are Brazil, South Africa, India, the Philippines, Indonesia and Peru. The complete list of our equity, fixed-income, credit and currency allocations are always presented at the end of our Weekly Reports, please refer to page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrade Indian Equities 4 October 2018 We are downgrading our allocation to Indian stocks from overweight to underweight within an EM-dedicated equity portfolio (Chart II-1). Rising stress in the country's non-bank finance companies - the recent default of finance company Infrastructure Leasing & Financial Services Limited and the fire-sale of Dewan Housing Finance bonds by a mutual fund - has been responsible for escalating financial risks, and will have ramifications for overall macro stability and growth. Stress Among Finance Companies: Liquidity Or Solvency? Finance companies account for about 12% of the MSCI India Stock Index. Further, there are deep interlinkages between them and mutual funds. Chart II-2 shows that mutual funds have exponentially increased their claims on non-bank finance companies by purchasing commercial paper (short-term debt obligations) issued by the latter. Chart II-1Failure To Break Out Is A Bad Omen Chart II-2Mutual Funds' Exposure To Finance Companies Further signs that the non-bank finance sector is having difficulties rolling over or repaying their debt obligations will hurt mutual funds. This might trigger redemptions from the latter by their own investors. Importantly, mutual funds' net purchases of equities as well as bonds has been very strong in recent years, often outpacing that of foreigners (Chart II-3). Given the former's large holdings of various securities, forced selling by mutual funds can often create an air pocket for Indian financial markets: local investors will be selling at a time when foreign investors are not yet ready to buy. Odds are considerable that stress will continue to escalate in the non-bank financial sector. Short-term interest rates and corporate bond yields are rising (Chart II-4). This is occurring at a time when non-bank finance companies are very vulnerable because of their liquidity mismanagement. Chart II-3Indian Mutual Funds Are Large Investors In Stocks And Bonds Chart II-4Rising Borrowing Costs Financial data from six non-bank finance companies included in the MSCI India Equity Index reveals that short-term debt levels for these companies are extremely elevated (Chart II-5, top panel) and their liquidity situation is grim. A measure of liquidity risk, calculated as short-term investments (including cash) minus short-term borrowing, has plummeted and is in deep negative territory (Chart II-5, bottom panel). In short, these finance companies have been borrowing short term and lending long term. Additionally, these entities will soon have to deal with surging non-performing assets (NPAs). Total assets for large finance companies - including the six companies included in the MSCI Equity Index - have grown at an annual average of around 20% since 2010. It is difficult to lend or invest at such a rapid pace while avoiding capital misallocation and the accumulation of bad assets. Crucially, the current level for NPAs for these six finance companies is 2.3% of risk-weighted assets, but could rise much further. Their provisions stand 2.1%, which barely covers existing NPAs. Hence, provisions have to rise multi-fold. For example, if NPAs rise to 12%, that would wipe out 32% of these companies' equity. We assume a recovery ratio of 30% on these bad assets. For comparison, the NPA ratio for overall the banking system has already surged to about 12%. Finally, commercial banks' lending to finance companies has been excessive in recent years (Chart II-6). Commercial banks are already swamped with rising non-performing loans, and any additional stress among finance companies will damage investor sentiment and negatively impact banks' share prices. Chart II-5Finance Companies: Liquidity Strains Are ##br##Rooted In Maturity Mismatches Chart II-6Banks' Exposure To Finance Companies Bottom Line: Odds are that the liquidity stress among finance companies will escalate and turn into a solvency problem. This will harm mutual funds in particular and cause them to liquidate their equity and bond holdings. Indian financial markets will selloff further. Limited Maneuvering Room For Central Bank High crude prices, rising inflation and mounting financial stress are placing the Reserve Bank of India (RBI) in an extremely precarious position: If the central bank provides sufficient liquidity or reduces interest rates to deal with budding stress in the financial system, the currency will plunge further; If the RBI does not provide sufficient liquidity or hikes rates to put a floor under the rupee, the stress in the financial system will worsen. It seems the central bank is currently biased to providing liquidity to contain financial system stress. In fact, the central bank has already injected bank reserves through the liquidity adjustment facility. In addition, it announced upcoming purchases of government securities in October in the order of Rs. 360 billion and has stressed its willingness to provide more injections if the need arises. This is negative for the currency which will continue to tumble, especially at a time when the U.S. dollar is well-bid worldwide. In turn, continued currency depreciation will make foreign investors net sellers of stocks and bonds. Bottom Line: We recommend investors downgrade India from overweight to underweight. We are also closing our long Indian banks / short Chinese banks at a 2% loss. Concerning equity sectors, we are reiterating our long Indian software companies' stocks / short EM overall equity benchmark. This trade is up 22%, and a cheaper rupee and strong DM growth herald further gains. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 A grey swan is an event that can be anticipated to a certain degree but is considered unlikely to occur and would have a sizable impact on financial markets if it were to occur. 2https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement/united-states-mexico# 3https://www-m.cnn.com/2018/10/01/politics/china-us-warship-unsafe-encounter/index.html?r=https%3A%2F%2Fwww.cnn.com%2F 4 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, a link available on page 16. 5 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?," dated April 6, 2018, available on ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report "Vladimir Putin, Act IV," dated March 7, 2018, link available on ems.bcaresearch.com. 7 Please see Emerging Markets Strategy Special Report "The Philippines: Duterte's Money Illusion," dated April 25, 2018, link available on ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot Chart 19The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities Appendix A Chart IIMarket Outlook: Bonds Appendix A Chart IIIMarket Outlook: Currencies Appendix A Chart IVMarket Outlook: Commodities Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades