Economic Growth
Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Chart 8Sovereigns Still##br## Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The U.S. labor market is now at full employment and the plethora of fiscal stimulus coming down the pike could cause the economy to overheat. If the recent rebound in the U.S. dollar reverses, this will only add to aggregate demand by boosting net exports. There are two main scenarios in which the U.S. can avoid overheating while the value of the greenback resumes its decline: 1) The Fed tightens monetary policy by enough to slow growth but other central banks tighten monetary policy even more; 2) the U.S. is hit by an adverse demand shock that forces the Fed to back away from further rate hikes. Neither scenario can be easily discounted, but both seem unlikely. The first scenario assumes that the neutral real rate of interest is fairly high outside the U.S., when most of the evidence says otherwise. The second scenario ignores the fact that adverse demand shocks, even if they originate from the U.S., tend to become global fairly quickly. Weaker global growth is usually bullish for the dollar. This suggests that the dollar rally has legs. EUR/USD is on track to hit 1.15 over the coming months, but a plunge below that level is possible given that the dollar is one of the most momentum-driven currencies out there. For now, investors should favor DM over EM equities and oil over metals. Feature Running Hot More than a decade after the Great Recession began, the U.S. labor market is back to full employment (Chart 1). The headline unemployment rate stands at 4.1%, below the Fed's estimate of NAIRU. Broader measures of labor slack, such as the U-6 rate, the number of workers outside the labor force wanting a job, and the share of the unemployed who have quit their jobs, are also back to pre-recession levels. Most business surveys show that companies are struggling to fill vacant positions (Chart 2). Wage growth is picking up, especially among low-skilled workers, whose compensation tends to be more closely tied to labor slack than their better-skilled counterparts (Table 1). Chart 1U.S. Is Back To Full Employment Chart 2Survey Data Point To Higher Wage Growth Ahead Table 1Wage Growth Is Accelerating Despite its recent rebound, the broad trade-weighted dollar is still down nearly 7% since its December 2016 high. According to the New York Fed's macro model, a sustained decline in the dollar of that magnitude would be expected to boost the level of GDP by about 0.5%. This would be equivalent to a permanent 50 basis-point cut in interest rates in terms of its effect on aggregate demand.1 Not that long ago, market participants and numerous pundits expected the dollar to continue its slide. Net short dollar positions reached their highest level in nearly six years in mid-April, before moving lower over the past two weeks (Chart 3). "Short dollar" registered as the second-most crowded trade in the monthly BofA Merrill Lynch survey of fund managers that was conducted between April 6 and 12, behind only "long FAANG-BAT stocks."2 Chart 3Short Dollar Is A Crowded Trade The Fed's Dilemma This raises an obvious question. If the consensus view that so many market investors subscribed to only a few weeks ago turns out to be correct and the dollar does give up its recent gains, how is the Fed supposed to tighten financial conditions by enough to keep the economy from overheating? One response is the Fed could raise rates by enough to slow growth. If the dollar falls while this is happening, so be it. The Fed can always hike rates more quickly in order to ensure that the contractionary effect of higher interest rates more than offsets the stimulative effect of a weaker dollar. The problem with this answer is that the dollar is only likely to weaken if other central banks are tightening monetary policy as much or more than the Fed. Chart 4 shows that the dollar has generally moved in line with interest rate differentials between the U.S. and its trading partners. Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials There is little scope for rate expectations to narrow at the short end of the yield curve if U.S. growth remains above trend for the remainder of the year, as we expect will be the case. This is simply because most other major central banks are in no hurry to raise rates. The ECB has effectively pledged not to raise rates until at least the middle of next year. The U.K. remains mired in a post-Brexit slump. The BoJ is nowhere close to meeting its 2% inflation target (20-year CPI swaps are still trading at 0.6%). There is some room for rate expectations to converge further along the yield curve. However, for that to happen, investors must come to believe that the gap in the neutral rate of interest between the U.S. and its trading partners will shrink. It is far from obvious that they will do so. The Neutral Rate Is Higher In The U.S. Than The Euro Area Consider a comparison between the U.S. and the euro area. A reasonable proxy for the market's view of the neutral rate is the expected overnight rate ten years ahead, which can be calculated using eurodollar and euribor futures. The spread currently stands at about 100 basis points in favor of the U.S., down from 150 basis points at the start of 2017. Taking into account the fact that market-based inflation expectations are somewhat lower in the euro area, the spread in real terms is close to 50 basis points. That is not a lot, considering all the reasons to suppose that the neutral rate is higher in the U.S.: U.S. fiscal policy is a lot more stimulative. The IMF expects the U.S. fiscal impulse, which measures the change in the structural budget deficit, to reach 0.8% of GDP in 2018 and 0.9% in 2019. The fiscal impulse in the euro area and most other economies is likely to be much smaller (Chart 5). While the U.S. fiscal impulse will fall back to zero in 2020-21 barring a fresh wave of tax cuts or spending increases, the difference in the structural fiscal balance between the U.S. and the euro area will still widen to a record high of 6% of GDP by then (Chart 6). It is this difference that determines the gap in neutral rates.3 The U.S. will feel decreasing private-sector deleveraging headwinds in the years ahead. Euro area private-sector debt, measured as a share of GDP, is above U.S. levels and still close to all-time highs. In contrast, U.S. private-sector debt is down by 18% of GDP from its 2008 peak (Chart 7). The demographic divide between the U.S. and the euro area will widen. A rising labor participation rate allowed the euro area's labor force to grow at virtually the same pace as the U.S. between 2000 and 2015 (Chart 8). However, now that the euro area participation rate is above the U.S., the scope for further structural gains in participation in the euro area are limited. Over the past two years, labor force growth in the euro area has fallen behind the United States. If this trend continues and labor force growth in the two regions converges to the underlying rate of growth in the working-age population, it could reduce euro area GDP growth by over 0.5 percentage points relative to U.S. growth. Slower GDP growth typically implies a lower neutral rate. Chart 5U.S. Fiscal Policy##br## Is More Stimulative Chart 6U.S. And Euro Area: Gap In Fiscal##br## Balances Will Hit Record Highs Chart 7Deleveraging Headwinds Will Be##br## Stronger In The Euro Area Than The U.S. Chart 8Slowing Euro Area Labor Force ##br##Participation Will Weigh On Growth When Things Go Sour If other major central banks find themselves hard-pressed to raise rates anywhere close to U.S. levels, how about the opposite case: The one where an adverse shock forces the Fed to cut rates towards overseas levels? Since interest rates in many other economies remain at rock-bottom levels, there is little scope for their central banks to cut rates even if they wanted to. In contrast, the Fed is no longer constrained by the zero bound, which gives it greater leeway to ease monetary policy. While such a scenario cannot be easily ruled out, it is mitigated by the fact that frothy asset markets in the U.S. have not produced large imbalances in the real economy. This stands in sharp contrast to the last two recessions. The Great Recession was exacerbated by a massive overhang of empty homes. The 2001 recession was aggravated by a huge overhang of capital equipment left in the wake of the dotcom bust. The surging dollar and increased Chinese competition also laid waste to a large part of the U.S. manufacturing base, necessitating a period of painful adjustment. Today, both the housing and manufacturing sectors are in reasonably good shape. This suggests that rates can rise further before growth stalls out. And even if the U.S. economy begins to flounder, it is not clear that this would lead to a weaker dollar. Remember that the U.S. mortgage market was the focal point of the Global Financial Crisis, and yet the dollar still strengthened by over 20% between July 2008 and March 2009. A recent IMF study concluded that changes in U.S. financial conditions have an outsized effect on growth outside the United States.4 Weaker global growth is generally good for the dollar (Chart 9). The old adage "When America sneezes, the rest of the world catches a cold" still rings true. If higher U.S. rates lead to a stronger dollar, this could put pressure on emerging markets. Similar to what transpired in the mid-to-late 1990s, a feedback loop could arise where rising EM stress causes the dollar to strengthen, leading to even more EM stress: A vicious circle for emerging markets, but a virtuous one for the greenback. Chart 10 shows that EM equities are almost perfectly inversely correlated with U.S. financial conditions. Chart 9Decelerating Global Growth Tends ##br## To Be Bullish For The Dollar Chart 10Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Investment Conclusions The dollar is bouncing back. This week's FOMC statement caused the greenback to briefly sell off before it rallied back. We do not think the Fed's decision to include the word "symmetric" in describing its inflation target was as important as some observers believe. The Fed has stressed that it has a symmetric target for many years. If anything, the inclusion of the word could mean that the Fed now realizes that it is behind the curve in normalizing monetary policy and thus wants to prepare the market for the inevitable inflation overshoot. That could mean more rate hikes down the road, not fewer. As such, we expect the dollar to continue strengthening. Our Foreign Exchange Strategy team's intermediate-term timing model sees EUR/USD hitting 1.15 in the next three-to-six months (Chart 11). A plunge below this level is possible given that the dollar is one of the most momentum-driven currencies out there (Chart 12). Chart 11Euro Is Poised To Weaken Chart 12The Dollar Is A Momentum-Driven Currency Sterling should also edge lower against the dollar over the next few quarters. Our global fixed-income strategists remain bullish on gilts, reflecting their view that the market has been too hawkish about how many hikes the BoE can deliver over the next year. Over a longer-term horizon, the pound has upside against both the U.S. dollar and most other currencies. If a new Brexit referendum were held today, the "remain" side would probably win (Chart 13). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The Japanese yen faces cyclical downside risks as global bond yields move higher, leaving JGBs in the dust. However, similar to sterling, the longer-term prospects for the yen are brighter. The currency is cheap and should benefit from Japan's large current account surplus and its status as a massive holder of overseas assets (Chart 14). Chart 13Bremorse Sets In Chart 14The Yen's Long-Term Outlook Is Bullish Emerging market currencies rallied between early 2016 and the beginning of this year, but have faltered lately (Chart 15). BCA's EM and geopolitical strategists expect the Chinese government to expedite structural reforms and take steps to slow credit growth and cool the bubbly housing market. We do not anticipate that this will lead to a proverbial hard landing, but it could put renewed pressure on commodity prices over the next few months. Metals are much more exposed to a China slowdown than oil (Chart 16). Correspondingly, we favor "oily" currencies such as the Canadian dollar over "metallic" currencies such as the Australian dollar. Chart 15EM Currencies Have Been ##br##Wobbling Of Late Chart 16Base Metals Are More Sensitive ##br##To Slower Chinese Growth As for risk assets in general, our model still points to near-term downside risks to global equities (Chart 17). However, we expect these risks to fade as global growth stabilizes at an above-trend pace. That should set the stage for a rally in developed market stocks into year-end. Chart 17MacroQuant* Model: Still Pointing To Moderate Downside Risks For Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Specifically, the New York Fed model says that a 10% depreciation in the dollar would be expected to raise the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative increase of 0.7%. A 7% decline in the dollar would thus translate into a 0.7*7 = 0.49% increase in GDP. Using former Fed chair Janet Yellen’s preferred specification of the Taylor rule equation, which assigns a coefficient of one on the output gap, a permanent 0.49% of GDP increase in net exports would have the same effect on aggregate demand as a permanent 49 basis-point decline in the fed funds rate. Assuming a constant term premium, this would also be equivalent to a 49 basis-point decline in long-term Treasury yields. 2 FAANG stands for Facebook, Apple, Amazon, Netflix, and Google. BAT stands for Baidu, Alibaba, and Tencent. 3 Conceptually, changes in the budget deficit drive changes in aggregate demand, whereas the level of the budget deficit drives the level of aggregate demand. One can see this simply by noting that aggregate demand is equal to C+I+G+X-M. A one-off increase in G temporarily lifts the growth rate in demand, but permanently increases the level of demand. The neutral rate is determined by the level of demand and not the change in demand because the neutral rate, by definition, is the interest rate that equalizes the level of aggregate demand with aggregate supply. 4 Please see “Getting The Policy Mix Right,” IMF Global Financial Stability Report, (Chapter 3), (April 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The greenback normally weakens when the U.S. business cycle matures; 2018 may prove an exception to this rule. Rising U.S. inflation could clash with deteriorating global growth, bringing the monetary divergence narrative back in vogue. This would help the dollar. EM assets are especially at risk from a rising dollar. Tightening EM financial conditions would ensue, creating additional support for the dollar. The yen is caught between bearish and bullish crosscurrents. Continue to favor short EUR/JPY and short AUD/JPY over bets on USD/JPY. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Feature Late in the business cycle, U.S. growth begins to slow relative to the rest of the world, and normally the U.S. dollar weakens in the process. The general trajectory of the dollar this business cycle is likely to end up following this historical pattern, and last year's decline for the greenback was fully in line with past experience. However, 2018 could be an odd year, where the dollar manages to rally thanks to a combination of softening global growth and rising inflationary pressures in the U.S., which forces the Federal Reserve to be less sensitive to the trajectory of global economic conditions than it has been since the recession ended in 2009. Normally, The USD Sags Late Cycle We have already showed that EUR/USD tends to rally once the U.S. business cycle matures enough that the Fed pushes interest rates closer to their neutral level. Essentially, because the eurozone business cycle tends to lag that of the U.S., the European Central Bank also lags the Fed, which also implies that European policy rates remain accommodative longer than those in the U.S. Paradoxically, this means that late in the cycle, European growth can outperform that of the U.S., and markets can price in more upcoming interest rate increases in Europe than in the U.S., lifting the euro in the process (Chart I-1). Chart I-1The Euro Rallies Late In The Business Cycle Not too surprisingly, these dynamics can be recreated for the entire dollar index. As Chart I-2 illustrates, when we move into the later innings of the business cycle, global growth begins to outperform U.S. growth, and in the process, the DXY weakens. There has been an exception to these dynamics - the late 1990s - when the dollar managed to rally despite the lateness of the U.S. business cycle. Back then, the dollar was in a bubble, and the strong sensitivity of the dollar to momentum (Chart I-3) helped foment self-fulfilling dollar strength.1 Moreover, EM growth was generally weak. This begs the question, could 2018 evoke the late 1990s? Chart I-2What Works For The Euro Mirrors What Works For The Dollar Chart I-3Momentum Winners: USD And JPY Crosses Bottom Line: Normally, the U.S. dollar tends to weaken in the later innings of the U.S. business cycle, as non-U.S. growth overtakes U.S. growth. However, in 1999 and in 2000, the dollar managed to rally despite the U.S. business cycle moving toward its last hurrah. Not A Normal Cycle This cycle has been anything but normal. Growth in the entire G-10 has been rather tepid. While it is true that potential growth, or the supply side of the economy, is lower than it once was, courtesy of anemic productivity growth and an ageing population, demand growth has also suffered thanks to a protracted period of deleveraging. But the U.S. has been quicker than most other major economies in dealing with the ills that ailed her, executing a quicker private sector deleveraging than the rest of the G-10 (Chart I-4). As a result, today the U.S. output and unemployment gaps are more closed than is the case in the rest of the G-10. As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Chart I-4The U.S. Delevered, It Is Now Reaping The Benefits Chart I-5The Fed Is Now Less Sensitive To Foreign Shocks As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Core PCE is now at 1.9%, and thus the 2% target is finally within reach. Just as importantly, 10-year and 5-year/5-year forward inflation breakevens have rebounded to 2.17% and 2.24% respectively, close to the 2.3% to 2.5% range - consistent with the Fed achieving its inflation target (Chart I-6). This implies that inflation expectations are getting re-anchored at comfortable levels for the Fed. As the threat of deflation and deflationary expectation passes, the Fed is escaping the fate of the Bank of Japan in the late 1990s. It also means that the Fed is now less likely to respond as vigorously to a deflationary shock emanating from outside the U.S. than was the case in 2016, when the U.S. economy still had plentiful slack, and realized and expected inflation was wobblier. The rest of the DM economies have not deleveraged, have more slack, and are more opened to global trade than the U.S. This exposure to the global economic cycle was a blessing in 2017, when global trade and global industrial activity were accelerating. But this is not the case anymore. As Chart I-7 illustrates, the Global Zew Economic Expectations survey is exhibiting negative momentum, which historically has preceded periods of deceleration in the momentum of global PMIs as well. Chart I-6Stage 1 Almost Complete The Fed Finally Enjoys ##br##Compliant Inflationary Conditions Chart I-7Downdraft In##br## Global Growth While this phenomenon is a global one, Asia stands at its epicenter. China's industrial activity is slowing sharply, as both the Li-Keqiang index2 and its leading index, developed by Jonathan LaBerge who runs BCA's China Investment Strategy service, are falling (Chart I-8, top panel). China is not alone: Korean exports and manufacturing production are now contracting on an annual basis; Singapore too is suffering from a clearly visible malaise (Chart I-8, middle and bottom panels). Advanced economies are also catching the Asian cold. Australia and Sweden, two small open economies, have seen key leading economic gauges slow (Chart I-9, top panel). Even Canadian export volumes have rolled over (Chart I-9, middle panel). Finally, the more closed European economy is showing worrying signs, with exports slowing sharply and PMIs rolling over. As we highlighted two weeks ago, even the European locomotive - Germany - is being affected, with domestic manufacturing orders now contracting on an annual basis.3 Chart I-8Asia Is The Source Of The Malaise Chart I-9The Cold Might Be Spreading This dichotomy between U.S. inflation and weakening global activity is resurrecting a theme that was all the rage in 2015 and 2016: monetary divergences. Fed officials sound as hawkish as ever and will likely push up the fed funds rate five times over the next 18 months even if global growth softens a bit. However, the ECB, the Riksbank, the Bank of England, the Reserve Bank of Australia, the Bank of Canada and even the BoJ are all backpedaling on their removal of monetary accommodation. They worry that growth is not yet robust enough, or that capacity utilization is not as high as may seem. The theme of monetary divergence will therefore likely be the result of non-U.S. central banks softening their rhetoric, not the Fed tightening hers. The end result is likely to cause a period of strength in the U.S. dollar, one that may have already begun. In fact, that strength is likely to have further to go for the following five reasons: First, as we showed in Chart I-3, the dollar is a momentum currency, and as Chart I-10 illustrates, the dollar's momentum is improving after having formed a positive divergence with prices. Chart I-10USD Momentum Is Picking Up Second, speculators and levered investors currently hold near-record amounts of long bets on various currencies, implying they are massively short the dollar (Chart I-11). This raises the probability of a short squeeze if the dollar's autocorrelation of returns stays in place. Chart I-11 Third, the dollar is prodigiously cheap relative to interest rate differentials (Chart I-12). While divergences from interest rate parity are common in the FX market, they never last forever. Thus, if monetary divergences become once again a dominant narrative among FX market participants, a move toward UIP equilibria will grow more likely. Fourth, rising Libor-OIS spreads have been pointing to a growing shortage of dollars in the offshore market. The decline in excess reserves in the U.S. banking system corroborates the view that liquidity is slowing drying up. Historically, these occurrences point to a strong dollar (Chart I-13). Chart I-12A Return To Interest-Rate##br## Parity? Chart I-13Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Fifth, a strong dollar tightens EM financial conditions (Chart I-14). This could deepen the malaise already visible in Asia that seems to be slowly spreading to the global economy. This last point is essential, as it lies at the crux of the reason why the USD is the epitome of "momentum currencies." Essentially, this reflects the importance of the dollar as a source of funding for emerging market governments and businesses. The amount of EM dollar debt has been rising. In fact, excluding China, dollar-denominated debt today represents 16% of EM GDP, 65% of EM exports and 75% of EM reserves - the highest levels since the turn of the millennium (Chart I-15). Practically, this means that the price of EM currencies versus the USD is a key component to the cost of capital in EM. Chart I-14The Dollar Is The Enemy ##br##Of EM Financial Conditions Chart I-15EM Have A Lot ##br##Of Dollar Debt Additionally, EM local currency debt instruments are exhibiting their highest duration since we have data, making them more vulnerable to higher global interest rates (Chart I-16). Hence, the capital losses resulting from a given move higher in interest rates have grown, sharpening the risk that EM bond markets could experience a violent liquidation event. Moreover according to the IIF, the average sovereign rating of EM debt is at its lowest level since 2009. Normally, the allocation of global institutional investors into EM debt is positively correlated with the quality of EM issuers, but today this allocation has risen to more than 12%, the highest share in over five years. This suggests that DM investors are overly exposed to EM risk, creating another source of potential selling of EM assets. Ultimately, these risk factors can create a powerful feedback loop that support the sensitivity of the dollar to momentum. A strong U.S. dollar hurts EM assets, which prompts overexposed global investors to sell EM currencies further. This can be seen in the negative correlation of the broad trade-weighted dollar and high-yield EM bond prices (Chart I-17, top panel). Additionally, because rising EM bond yields as well as falling EM equities and currencies tighten EM financial conditions, this hurts EM growth. However, the U.S. economy is not as sensitive to EM growth as the rest of the world is.4 As a result, weakness in EM assets also translates into dollar strength against the majors (Chart I-17, middle panel). Additionally, commodity currencies tend to suffer more in this environment than European ones, as shown by the rallies in EUR/AUD concurrent with EM bond price weakness (Chart I-17, bottom panel). These risky dynamics in EM markets therefore are a key reason why we expect the U.S. dollar to be able to rally, bucking the normal weakness associated with the late stages of a U.S. business cycle expansion. Specifically, EUR/USD is set to suffer this year as the euro's technical picture has deteriorated significantly (Chart I-18), and, as we argued two weeks ago, the euro area still has plenty of slack. Chart I-16Heightened EM Duration Risk Chart I-17EM Risks Help The Greenback Chart I-18EUR/USD Technicals Are Flimsy Bottom Line: For the remainder of 2018, the dollar is likely to buck the weakness it normally experiences in the late innings of a .S. business cycle expansion. The U.S. is significantly ahead of the rest of the world when it comes to inflation, giving more room for the Fed to hike rates. This difference is now put in sharper focus than last year as the global economy is weakening, which could prompt a period of dovish rhetoric in the rest of the world that will not be matched by an equivalent backtracking in the U.S. Moreover, while positioning and technical considerations also favor a dollar rebound, the vulnerability of EM assets increases this risk by creating an additional drag on foreign growth. What To Do With The Yen? The yen currently sits at a tricky spot. Historically, the yen tends to depreciate against the USD when we are at the tail end of a U.S. business cycle expansion (Chart I-19). Toward the end of the business cycle, U.S. bond yields experience some upside - upside that is not mimicked by Japanese interest rates. The resultant widening in interest rate differentials favors the dollar. Chart I-19The Yen Doesn't Enjoy Late Cycle Dynamics On the other hand, a period of weakness in EM assets, even if prompted by a dollar rebound, could help the yen. The yen is a crucial funding currency in global carry trades, and a reversal of these carry trades will spur some large yen buying. Moreover, Japan has a net international investment position of US$3.1 trillion. This means that Japanese investors, who are heavily exposed to EM assets, are likely to repatriate some funds back home. So what to do? We have to listen to economic conditions in Japan. So far, despite an unemployment rate at 25-year lows and a job-opening-to-applicant ratio at a 44-year highs, Japan has not been able to generate much inflationary pressures. In fact, while the national CPI data has remained robust, the Tokyo CPI, which provides one additional month of data, has begun to roll over (Chart I-20). The Japanese current account is deteriorating sharply. This mostly reflects the downshift in EM economic activity as 44% of Japanese exports are destined to those markets. Interestingly, in response to the deterioration in export growth, import growth is also decelerating sharply, pointing toward a domestic impact from the foreign weakness (Chart I-21). It is looking increasingly clear that overall economic momentum in Japan is slowing. Both the shipment-to-inventory ratio as well as the Cabinet Office leading diffusion index are exhibiting sharp drops - signs that normally foretell a slowdown in industrial production and therefore a deterioration in capacity utilization, which still stands well below pre-2008 levels (Chart I-22). Chart I-20Weakening Japanese Inflation Chart I-21The Asian Malaise Is Hitting Japan Chart I-22Japanese Outlook Deteriorating In response to these developments, BoJ Governor Haruhiko Kuroda has been sounding more dovish. Moreover, after its latest policy meeting, the BoJ is acknowledging that it will take more time than anticipated for inflation to move toward its 2% target. In this environment, the yen has begun to weaken against the USD, especially as the greenback has been strong across the board. Moreover, USD/JPY was already trading at a discount to interest rate differentials. The downshift in Japanese economic data as well as the shift in tone by the BoJ are catalyzing the closure of this gap. Practically talking, USD/JPY is currently a very dangerous cross to play, as it is caught between various cross currents: a broad-based dollar rebound and a BoJ responding to a slowing economy can help USD/JPY; however, rising EM risks could boost it. On balance, we now expect the bullish USD forces to prevail on the yen, but we are not strongly committed to this view. Instead, have long maintained that the higher probability vehicle to play the yen is to short EUR/JPY.5 We remain committed to this strategy for the yen. Based on interest rate differentials, the price of commodities and global risk aversion, the euro can decline further against the yen, as previous overshoots are followed with significant undershoots (Chart 23, left panels). Moreover, speculators remains too long the euro versus the yen (Chart I-23, right panels). Additionally, EUR/JPY remains expensive on a long-term basis, trading 13% above its PPP-implied fair value. Finally, in contrast to Japan's large positive net international investment position, Europe's stands at -4.5% of GDP. Japanese investors have proportionally more funds held abroad than European investors do, and therefore more scope to repatriate funds in the event of rising EM asset volatility. We have also highlighted that selling AUD/JPY, while a more volatile bet than being short EUR/JPY, is another attractive way to play the risk to EM markets. Not only is AUD/JPY still very overvalued (Chart I-24), but Australia remains highly exposed to EM growth. This remains an attractive bet, despite a good selloff so far this year. Chart I-23AShort EUR/JPY Is A Cleaner Story (I) Chart I-23BShort EUR/JPY Is A Cleaner Story (II) Chart I-24AUD/JPY Is At Risk Bottom Line: The yen tends to depreciate against the USD in the later innings of a U.S. business cycle expansion, a response to rising U.S. bond yields. However, the yen also benefits when EM asset prices fall, a growing risk at the current economic juncture. Moreover, Japanese economic data are deteriorating and the BoJ is shifting toward a more dovish slant. The balance of these forces suggests that the yen rally against the dollar is done for now. However, the yen has further scope to rise against the EUR and the AUD. Two Charts On EUR/GBP Since we are anticipating EUR/USD to fall further toward 1.15, this also begs questions for the pound. Historically, a weak EUR/USD is accompanied by a depreciating EUR/GBP (Chart I-25). Essentially, the pound acts as a low-beta euro against the USD, and therefore when EUR/USD weakens, GBP/USD weakens less, resulting in a falling EUR/GBP. This time around, British economic developments further confirm this assessment. The spread between the British CBI retail sales survey actual and expected component has collapsed, pointing to a depreciating EUR/GBP (Chart I-26). Essentially, the brunt of the negative impact of Brexit on the British economy is currently being felt, which is affecting investor sentiment on the pound relative to the euro. Why could consumption, which represents nearly 70% of the U.K. economy, rebound from current poor readings? Once inflation weakens - a direct consequence of the previous rebound in cable - real incomes of British households will recover from their currently depressed levels, boosting consumption in the process. Chart I-25Where EUR/USD Goes,##br## EUR/GBP Follows Chart I-26Economic Conditions Also Point ##br##To A Weakening EUR/GBP Finally, today only 42% of the British electorate is pleased with having voted for Brexit, the lowest share of the population since that fateful June 2016 night. Moreover, this week, the House of Lords voted that Westminster can adjust the final deal with the EU before turning it into law. This implies that the probability of a soft Brexit, or even no Brexit at all, is increasing. However, the challenge to Theresa May's post-Brexit customs plan by MP Rees-Mogg, is creating yet another short-term hurdle that makes the path toward this outcome rather torturous. Additionally, it also raises the probability of a Corbyn-led government if the current one collapses. As a result, while the economic developments continue to favor being short EUR/GBP, the political environment is still filled with landmines, creating ample volatility in the pound crosses. We will use any rebound to EUR/GBP 0.895 to sell this pair. Bottom Line: If the euro weakens further, GBP/USD is likely to follow and depreciate as well. However, the pound will likely rally against the euro. Historically, GBP/USD behaves as a low-beta version of EUR/USD. Moreover, the maximum post-Brexit economic pain is potentially being felt right now, implying a less cloudy economic outlook for the U.K. Additionally, the probability of a soft Brexit or no Brexit at all is growing even if partial volatility remains. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 The Li-Keqiang index is based on railway cargo volume, electricity consumption, and loan growth. 3 Please see Foreign Exchange Strategy Weekly Report, titled "The ECB's Dilemma", dated April 20, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YYC!", dated January 12, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was marginally positive this week. As headline PCE climbed to the targeted 2% level, the underlying core PCE also edged up to 1.9%, highlighting growing inflationary forces. However, countering these positive releases were disappointing PMIs and a slowing ISM, as well as pending home sales, which contracted on a 4.4% annual basis. Regardless, the Fed acknowledged the strength of the U.S. economy. The FOMC referred to the inflation target as "symmetric", signaling that for now, inflation above target will not be used as an excuse to lift rates faster than currently forecasted in the dots. Nevertheless, the much-awaited breakout in the dollar materialized two weeks ago. As global growth wains, key central banks such as the ECB, BoJ, and BoE are likely to retreat to a more dovish tilt, as growth forecasts are revised down. This should give the greenback a substantial boost this year. Report Links: Is King Dollar Facing Regicide? - April 27, 2018 U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was weak: M3 and M1 money supply growth both weakened to 3.7% and 7.6%; Annual GDP growth slowed down to 2.5%, as expected; Both the headline and core measures of inflation disappointed, coming in at 1.2% and 0.7%, respectively. The euro broke down below a crucial upward-slopping trendline, which was defining the euro's rally last year. Additionally, EUR/USD has also broken the 200-day moving average technical barrier, highlighting the impact on the euro of weakening global growth and faltering European data. This decline in activity, along with the presence of hidden-labor market slack have been picked up by President Mario Draghi and other key ECB officials. Therefore, weakness in the euro is likely to continue for now. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei manufacturing PMI surprised to the upside, coming in at 53.8. However, Tokyo inflation ex-fresh food underperformed expectations, coming in at 0.6%. Moreover, consumer confidence also surprised negatively, coming in at 43.6. Finally, housing starts yearly growth underperformed expectations, coming in at -8.3%. The Bank of Japan decided to keep its key policy rate at -0.1% last Friday. Overall, the BoJ sounded slightly more dovish, acknowledging that it might take more time for inflation to move to their 2% target. Taking this into account, it might be dangerous to short USD/JPY as the BoJ could adjust policy to depreciate the currency. However investors could short EUR/JPY to take advantage of increased risk aversion. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 1.2%. Moreover, manufacturing PMI also surprised to the downside, coming in at 53.9. Additionally, both consumer credit and mortgage approvals underperformed expectations, coming in at 0.254 billion pounds, and 62.014 thousand approvals respectively. The pound has depreciated by nearly 5.5% in the past 2 weeks. Poor inflation and economic data as well as generalized dollar strength. Overall, we continue to be bearish on the pound, as the uncertainty surrounding Brexit will continue to scare away international capital. Moreover, the strength of the pound last year should weigh significantly on inflation, limiting the ability of the BoE to raise rates significantly. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was generally good: Building permits picked up, growing at a 14.5% annual rate, and a 2.6% monthly rate, beating expectations; The trade balance outperformed expectations comfortably, coming in at AUD 1.527 million; However, the AIG Performance of Manufacturing Index went down to 58.3 from 63.1; The AUD capitulated as a result of the growing global growth weakness, trading at just above 0.75. The RBA is reluctant to hike rates as Governor Lowe sited both stress in the money market and stretched household-debt levels as key reasons for his reluctance to hike. In other news, growing tension between Australia and its largest investor, China, are emerging in response to rumors that Chinese agents have been lobbying Australian officials in order to influence Australian politics. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The unemployment rate surprised positively, coming in at 4.4%. Moreover, employment quarter-on-quarter growth outperformed expectations, coming in at 0.6%. However, the Labour cost index yearly growth surprised to the downside, coming in at 1.9%. Finally, the participation rate also surprised negatively, coming in at 70.8%. NZD/USD has depreciated by nearly 5%. Overall we continue to be negative on the kiwi, given that an environment of risk aversion will hurt high carry currencies like the New Zealand dollar. Moreover, a slowdown in global growth should also start to hurt the kiwi economy, given that this economy is very levered to China and emerging markets. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Raw material price index increased by 2.1% in March, more than the expected 0.6%; GDP grew at a 0.4% monthly rate, beating expectations of 0.3%; However, the Markit manufacturing PMI disappointed slightly at 55.5. The CAD only suffered lightly despite the greenback's rally. Governor Poloz argued that the expensive Canadian housing market and the elevated household debt load have made the economy more sensitive to higher interest rates than in the past. He also pointed out that interest rates "will naturally move higher" to the neutral rate level, ultimately giving mixed signals. Despite these mixed comments by Poloz, the CAD managed to rise against most currencies expect the USD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales yearly growth underperformed expectations, coming in at -1.8%. Moreover, the KOF leading indicator also surprised negatively, coming in at 105.3 However, the SVME Purchasing Manager's Index came in at 63.9. EUR/CHF has been flat these last 2 weeks. Overall, we continue to bullish on this cross on a cyclical basis, given that the SNB will keep intervening in currency markets, as the economy is still too weak, and inflationary pressures are still to tepid for Switzerland to sustain a strong franc. However, EUR/CHF could see some downside tactically in an environment of rising risk aversion. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Registered unemployment surprised positively, coming in at 2.4%. Moreover, the Norges Bank credit indicator also outperformed expectations, coming in at 6.3%. USD/NOK has risen by more than 4% these past 2 weeks. This has occurred even though oil has been flat during this same time period. Overall we are positive on USD/NOK, as this cross is more influenced by relative rate differentials between the U.S. and Norway than it is by oil prices. However, the krone could outperform other commodity currencies, as oil should outperform base metals, as the latter is more sensitive to the Chinese industrial cycle than the latter. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona's collapse seem never ending. While the krona never responds well to an environment where global growth is weakening and where asset prices are becoming more volatile, Riksbank governor Stefan Ingves is not backing away from his dovish bias. In fact, the Swedish central bank is perfectly pleased with the krona's dismal performance. Thus, the Riksbank is creating a stealth devaluation of its currency, one that is falling under President Donald Trump's radar. Swedish core inflation currently stands at 1.5%, but it is set to increase. The Riksbank's resource utilization gauge is trending up and the Swedish housing bubble is supporting domestic consumption. As a result, the Swedish output gap is well above zero, and wage and inflationary pressures are growing. The Riksbank will ultimately be forced to hike rates much faster than it currently forecasts. Thus, we would anticipate than when the global soft patch passes, the SEK could begin to rally with great alacrity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations
Highlights Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. Recent data suggests that China's industrial sector continues to slow. We also see more downside risk from monetary policy and the pace of structural reform than the market, underscoring that our stance towards China is a low-conviction overweight. Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight Taiwan within Greater China bourses. Feature Chart 1Ex-Tech Stocks Edging Closer##BR##To A Breakdown Vs Global Chinese ex-technology stock prices edged closer to a technical breakdown in April (Chart 1), as ongoing concerns about the impact of a trade war with the U.S. weighed further on investor sentiment. Consumer discretionary stocks have fared particularly poorly, as President Xi's pledge to open up the auto sector (which is negative for the market share of domestic firms) underscores that car producers are facing a losing scenario even if a further escalation in trade tension with the U.S. is avoided. Panel 2 of Chart 1 shows that recent decline has brought consumer discretionary stocks back to early-2017 levels relative to the broad market. The selloff in the consumer discretionary sector has significantly benefitted one of China Investment Strategy's open trades: long investable consumer staples / short investable consumer discretionary, initiated on November 16. The trade had already been outperforming prior to Xi's pledge in response to the original basis that we articulated (negative impact on autos from environmental reforms), but the news of a likely deterioration in market share has helped the trade earn a whopping 20% in less than 6 months. We recommend that investors stick with the call for now, until greater clarity emerges about the ultimate impact of trade negotiations with the U.S. But we have also recommended that investors place Chinese ex-tech stocks on downgrade watch for Q2 (while maintaining an overweight stance versus global equities), and that technical measures should be watched closely to determine whether a downgrade is indeed warranted. Within this framework, the recent deterioration in performance is worrying, raising the question of whether it is time for investors to reduce their exposure to ex-tech shares. Stay Overweight, For Now... Three factors point to "no" as the answer: Chart 2A Pro-Cyclical Allocation Is Consistent##BR##With A China Overweight Despite the weakness of Chinese stock prices over the past few weeks, they have not yet broken down technically: Chart 1 highlighted that their relative performance versus global stocks remains above its 200-day moving average. For now, this is consistent with a worsening in sentiment rather than full-fledged expectations of a sharp deterioration in equity fundamentals. Investors are clearly reacting to the negative potential effect of trade protectionism on ex-tech earnings, the ultimate impact of which remains subject to negotiation. We singled out consumer discretionary stocks as being likely to fare poorly under any realistic trade outcome, but the decline in Chinese relative performance since mid-April has occurred across all sectors, suggesting that a reversal may occur outside of the discretionary sector if a trade deal is struck with the U.S. Talks in China between high level U.S. and Chinese officials tomorrow and Friday are a hopeful sign that a relatively beneficial deal for both sides may be possible, suggesting that it is too early to cut exposure. Over a 1-year time horizon, BCA continues to recommend that investors remain overweight global equities within an overall balanced portfolio. We have highlighted in previous reports that the Chinese investable stock market is now a decidedly high-beta equity market versus the global benchmark (even in ex-tech terms),1 meaning that an overweight stance is justified barring a significantly negative alpha. Since Chart 2 illustrates that Chinese ex-tech stocks have in fact generated a modestly positive alpha over the past year, a pro-cyclical asset allocation stance continues to favor an above-benchmark weight to Chinese equities ex-technology. For now, our investment recommendations remain unchanged: investors should stay overweight Chinese stocks excluding the technology sector over the coming 6-12 months. But as highlighted below, the risks to China are clearly to the downside, which supports our decision to place Chinese stocks on downgrade watch for Q2. This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S./China trade dispute as well as the pace of decline in China's industrial sector will emerge. Bottom Line: Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. ...But The Risks Are To The Downside Table 1 updates our macro data monitor that we have published in a few previous reports. The monitor tracks the data series that we found to have the most reliable leading properties when predicting the Li Keqiang index (LKI),2 which we have defined as the most relevant proxy of China's business cycle. Table 1No Convincing Signs Of An##BR##Impending Upturn In China's Economy Chart 3Lower Inventories =##BR##A Rise In Housing Construction? The table now shows a March datapoint for all of the series that we track, and continues to argue that the trend in Chinese industrial activity is down. In particular, it appears to confirm that the elevated January/February levels in Bloomberg's calculation of the LKI were likely noise, and not a signal of an impending uptrend. The table highlights that none of the components of our leading indicator for the LKI are above their 12-month moving average, and 5 out of the 6 components fell in March. While the April update of the Caixin manufacturing PMI is being released as we go to press, the official manufacturing PMI also fell in April. On the housing front, floor space sold, one of the most important leading indicators for residential construction activity in China, has also decelerated over the past two months. In last week's joint Special Report with our Emerging Markets Strategy service, my colleague Ellen JingYuan He noted that steel prices are at risk not only because of a likely increase in supply, but from weaker demand due to a potential slowdown in the property market. BCA's China Investment Strategy service has actually taken a cautiously optimistic stance towards the housing market, and noted in an early-February report that there were a few signs of a pickup in activity.3 Chart 3 presents the most hopeful case, which is that the multi-year downtrend in residential construction relative to sales may be over given the significant reduction in housing inventories that has occurred over the past two years. Still, the level of inventories remains quite elevated by conventional standards, and it is difficult to see growth in residential construction sustainably rise if floor space sold remains weak, as it has been for the past two months. Given the recent evolution of the important macro data from China, our view is that the downside risk to the industrial sector should be clear to most investors. However, the potential for monetary policy easing and the extent of the tailwind for China from global growth remain two areas where we see more downside risk than some in the market. On the policy front, China's recent cut in the reserve requirement ratio (RRR) was greeted by some analysts as a sign of easing monetary policy, with others pointing to the recent decline in government bond yields as a clear sign that China's monetary policy is about to become less restrictive. However, we explained in a recent Special Report why the 3-month repo rate is currently the de-facto policy rate,4 and Chart 4 highlights that it appears to lead yields at the short-end. The recent tick down in the latter appears to be a delayed response to the sharp decline in the former, which preceded the RRR cut. Specifically, the repo rate slide was triggered by news reports in late-March that the deadline for new rules to be imposed on China's asset management industry would be extended, which is consistent with our argument that roughly 3/4ths of the tightening in monetary policy that has occurred since late-2016 has actually been regulatory/macro-prudential in nature. Given that the 3-month repo rate has since rebounded back to its post-2017 average following the announcement, we see no indication of any intension by the PBOC to ease monetary policy. Concerning trade, while the threat to China's export growth from U.S. protectionism is obvious, some investors have argued that global demand may be strong enough to overwhelm this negative effect and that it will buoy Chinese export growth (and, by extension, imports). This line of reasoning has a strong basis; Chart 5 shows that our BCA Global LEI is forecasting solid industrial production (IP) growth over the coming few months, and we have noted in past reports that there is a strong link between global IP and Chinese export growth. Chart 4No Convincing Signs Of Monetary Easing Chart 5Global Demand Likely To Remain Solid But Chart 6 presents a problem with this argument, which is that China's reform pain threshold is very likely positively correlated with global growth. In short, BCA has written extensively about how China has embarked on a multi-year reform effort that will likely weigh on growth in its early stages. We have made it clear that the pace of these reform efforts is likely to be responsive to the pace of economic growth (i.e. policymakers will set the pace to avoid a major growth slowdown), but the other side of this coin is that policymakers are likely to take advantage of a stronger export sector by increasing the pace of reforms. So while some investors view the external sector of China's economy as having some potential to counter weakness in the industrial sector if major protectionist action can be avoided, our sense is that ramped up reform efforts will offset and possibly overwhelm this positive factor, were it to occur. As a final point, in the context of Chart 6, material easing in either policy rates or the pace of reform efforts may occur over the coming 6-12 months, but it would likely be in response to a more serious slowdown in the economy than we are currently observing. As we noted in our April 18 Weekly Report,5 the possibility that Chinese authorities will need to stimulate the economy over the coming year is interesting because it raises the prospect of another economic mini-cycle in China, potentially leading to another meaningful acceleration. But the economic and financial market circumstances that would precede such an event are unlikely to be happy ones for investors, raising the risk of a serious selloff in China-related assets before policy eases sufficiently to return to an overweight stance. Chart 6If Demand For Chinese Exports Stays Strong,##BR##Reform Efforts Will Intensify Bottom Line: Recent data suggests that China's industrial sector continues to slow. We also see more downside risk than many investors from monetary policy and the pace of structural reform, underscoring that our stance towards China is a low-conviction overweight. An Update On Taiwanese Equities We last wrote about Taiwanese stocks in our December 14 Weekly Report,6 and argued that investors stick with our short MSCI Taiwan / long MSCI China trade and our underweight stance towards Taiwan vs Greater China bourses, despite extended technical conditions. Our recommendation was based on the argument that Taiwanese tech sector underperformance had been driven by material strength in the trade-weighted Taiwanese dollar (TWD), and that a lasting depreciation in the currency would be the most likely catalyst for a re-rating. Since our report in December, the relative performance of Taiwanese stocks has been volatile. After a period of underperformance versus Greater China stock prices, Taiwanese stocks then rose sharply in relative terms from late-February to early-April. The magnitude of the rise was sufficiently large to cause the relative price index to break above its 200-day moving average (Chart 7). However, Taiwanese relative performance has reversed course over the past month, retracing over half of the February to April surge. Chart 8 highlights that these confusing moves in Taiwanese stock prices versus Greater China have largely reflected passive outperformance in two sectors: tech sector outperformance versus China, and banking industry group outperformance versus global banks. On the tech front, Chinese tech stocks have been under pressure over the past month due to the tech-focused nature of U.S. import tariffs, and global investors appear to believe that Taiwanese tech stocks would not be as impacted by these tariffs as their Chinese peers. We disagree, as the export intensity of Taiwan's tech sector to China is quite high: exports to China account for 15% of Taiwan's GDP, and electronic components (i.e. semiconductors) account for nearly half of exports to China. This suggests that the tariff impact on Taiwan's tech sector will be sizeable even if it is indirect. Chart 7A Volatile Relative##BR##Performance Trend Chart 8Tech And Banks Have Driven Recent##BR##Developments In Relative Performance On the banking front, Chart 9 highlights that the outperformance of Taiwanese banks versus their global peers has occurred due to a failure of the former to selloff with the latter over the past few months. Global banks appear to be reacting to the recent flattening in the global yield curve caused by a rise at the short-end, whereas there is no sign of upcoming monetary policy tightening in Taiwan and Taiwanese banks have historically been low-beta versus their global peers (Chart 10). Chart 9Taiwanese Banks Have Passively##BR##Outperformed Global Banks Chart 10Continued Bank Outperformance Not##BR##Likely Barring A Decline In Global Equities We doubt that Taiwan's banks will continue to outperform global banks over the coming 6-12 months without a generalized selloff in global stock prices. As we noted earlier, BCA's house view is overweight global equities (and financials) over the cyclical horizon on the basis of still-strong global growth, stimulative U.S. fiscal policy, and the view that global monetary policy will not reach restrictive territory over the coming year. As such, we are inclined to lean against the recent outperformance of Taiwanese banks and, by extension, the trend in ex-tech relative performance. Bottom Line: Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight within Greater China bourses. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China: No Longer A Low-Beta Market," published January 11, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "Is China's Housing Market Stabilizing?," published February 8, 2018. Available at cis.bcaresearch.com. 4 Please see BCA Research's China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," published February 22, 2018. Available at cis.bcaresearch.com. 5 Please see BCA Research's China Investment Strategy Weekly Report "The Question That Won't Go Away," published April 18, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst," published December 14, 2017. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Looking Beyond The Next Few Months The next couple of months could remain tricky for equity markets. But, with economic growth set to remain above trend for another year or so and central banks cautious about the pace of monetary tightening, we continue to expect risk assets to outperform over the 12-month horizon. To begin, our short-term concerns. Global growth has clearly slowed in recent months, with Q1 U.S. GDP growth coming in at 2.3%, well below the 2.9% in Q4; global PMIs have also come down from their recent peaks, led by the euro zone and Japan (Chart 1). Inflation has begun to spook investors, with a sharp pick-up in core U.S. inflation, including a rise to 1.9% YoY in the core PCE inflation measure that the Fed watches most closely (Chart 2). Geopolitics will dominate the headlines over the next six weeks, with the waiver on Iran sanctions expiring on May 12, the end of the 60-day consultation for U.S. tariffs on China on May 21, the possible imposition of tariffs on $50 billion of Chinese goods starting on June 4, and likely developments with North Korea and NAFTA. Recommended Allocation Chart 1Global Growth Has Slowed Chart 2...And Inflation Picked Up Investors inclined to make short-term tactical shifts might, therefore, want to reduce risk over the next one to three months. For most clients of the Global Asset Allocation service with a longer perspective, however, we continue to recommend an overweight on equities and other risk assets. In the U.S., in particular, fiscal stimulus will, according to IMF estimates, boost GDP growth by 0.8 percentage points this year and 0.9 percentage points next (Chart 3). U.S. corporate earnings should grow by almost 20% this year and around 12% next and, while this is already in analysts' forecasts, it is hard to imagine equity markets struggling against such a strong backdrop. Not one of the recession/bear market warning signals we are watching (inverted yield curve, rising credit spreads, Fed policy in restrictive territory, significant decline in PMIs, peak in cyclical spending) is yet flashing. Neither do we see any signs that higher interest rates or expensive energy prices are slowing growth. Lead indicators of capex have come off a little, but still point to robust growth (Chart 4). The housing market tends to be the most vulnerable to rising rates and the average rate on a 30-year U.S. fixed mortgage has risen to 4.5% (from 3.7% at the start of the year and a low of 3.3% in late 2016). But housing data still look strong, with a continued rise in house prices and mortgage applications steady (Chart 5). Perhaps the sector most vulnerable to rising U.S. rates in this cycle is emerging markets, where borrowers have grown foreign-currency debt to $3.2 trillion, according to the BIS - one reason for our longstanding caution on EM assets (Chart 6). With crude oil rising to $75 a barrel, U.S. retail gasoline prices now average $2.80 a gallon, up from below $2 in 2016, and transportation companies are complaining of rising costs. But, historically, oil prices have needed to rise by 100% YoY before they triggered recession (Chart 7). Chart 3U.S. Stimulus Will Boost The Economy Chart 4Capex Remains Robust Chart 5No Signs Of Higher Rates Hurting Housing Chart 6Could EM Be Most Affected By Higher Rates? Chart 7Oil Hasn't Risen Enough To Cause Recession Eventually, however, strong growth, especially in the U.S., will become a headwind for risk assets. There is still some slack in the labor market, with another 500,000 people likely to return to work eventually (Chart 8). When that happens, perhaps early next year, the currently sluggish wage growth will begin to accelerate. Fiscal stimulus is likely to prove inflationary, since it is unprecedented for a government to stimulate the economy so aggressively when it is already close to full capacity (Chart 9). These factors will push inflation expectations back to their equilibrium level, and the market will then need to adjust to the Fed accelerating the pace of rate hikes to choke off inflation, which will push up real bond yields (Chart 10). Chart 8Still 500,000 Who Could Return To Work Chart 9Stimulus Unprecedented In Such A Strong Economy Chart 10Eventually Real Rates Will Need To Rise When that starts to happen - perhaps late this year or early next year - the yield curve will invert, and investors will start to price in the next recession. That will be the time to turn defensive, but it is still too early now. Fixed Income: Markets are currently pricing only a 50% probability of three more Fed hikes this year, and only two hikes next year. As markets start to anticipate further tightening, long rates are also likely to rise (Chart 11). We see 10-year U.S. Treasury yields at 3.3-3.5% by year-end, and so recommend an overweight in TIPs and a short duration position. The ECB is unlikely to need to rush rate hikes, however, given the slack in the euro zone (Chart 12), and so the spread between U.S. and core euro yields should widen further. Corporate credit spreads are unlikely to contract further but, as long as growth continues, we see U.S. high-yield bonds, in particular, providing attractive returns within the fixed-income bucket. Our bond strategists find that between the 2/10 yield curve crossing below 50 BP and its inverting, high-yield debt has since 1980 given an annualized 368 BP of excess return.1 Chart 11Fed Expectations Drive Long Rates Chart 12Still Plenty Of Slack In The Euro Zone Equities: Our preference remains for developed equities over emerging, and for more cyclical, higher-beta markets such as euro zone and Japan. The risk of a stronger yen over the coming months is a concern for Japanese equities in local currency terms but, as our recommendations are expressed in U.S. dollars, the currency effect cancels out, and so we keep our overweight for now. At this stage of the cycle our preference is for value stocks (especially financials) over growth stocks (especially IT): value/growth usually performs in line with cyclicals/defensives, but the relationship has moved out of sync in the past year or so (Chart 13), mostly because of the performance of internet stocks, whose premium valuation makes them very vulnerable to any bad news. Currencies: A widening of interest-rate differentials between the U.S. and euro zone is likely to push down the euro against the U.S. dollar over the next few months, especially given how crowded the long-euro trade has become. The vulnerability of EM currencies to rising U.S. rates has been seen in the past few weeks, with sharp falls in currencies such as the Turkish lira, Brazilian real, and Russian ruble. We expect this to continue. Overall, we expect a moderate appreciation of the trade-weighted U.S. dollar over the next 12 months. Commodities: The crude oil price continues to rise in line with our forecasts, and we expect to see Brent crude above $80 a barrel before the end of the year. The price next year will depend on whether the OPEC agreement is extended, and how much U.S. shale oil production reacts to the higher price. On the assumption of a moderate increase in supply from both OPEC and the U.S., the crude price is likely to fall back moderately in 2019. We see the long-term equilibrium crude price in the $55-65 range, the level where global supply can be increased enough to satisfy around 1.5% annual growth in demand. We remain more cautious on industrial commodities, and see the first signs coming through of a slowdown in China, which will dent demand (Chart 14). Chart 13Value Stocks Look Attractive Chart 14Signs Of China Slowing Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt," dated 24 April, 2018, available at usbs.bcaresearch.com GAA Asset Allocation
Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios Table I-410-year Treasury Return Scenarios We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth Chart I-6U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) Chart I-8BIMF Projections (II) U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... Chart II-14...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst