Equities
Highlights Midterm election is yet another geopolitical headwind to the markets this summer; A "lame duck" Trump could seek relevance abroad, with aggressive foreign and trade policy; Investors would be right to fret about a hard turn to the left by the Democratic Party; Democrats have 60% probability of taking the House and 45% probability of taking the Senate; On a cyclical horizon, midterm election will not undermine pro-business policies of the Trump administration, but may signal a paradigm shift over a more structural time horizon. Feature Geopolitical winds have turned from tailwinds to headwinds. This is as we expected last April, when we correctly forecast that geopolitical risks were overstated in 2017 but understated for 2018.1 This January we focused on several key risks for 2018: trade protectionism, Iran-U.S. geopolitical tensions, and a potential black swan risk in Taiwan.2 In our 2018 Strategic Outlook, we also pointed out that if Donald Trump becomes an early "lame duck" president, he will seek relevance abroad.3 It is therefore time to turn to the question of the upcoming midterm election, set to take place on November 6. For most of our clients, the midterm election is another volatile political event to add to an already long list (Table 1). True, the midterm election could produce a gridlocked Congress - which we recently showed quantitatively is marginally negative for the markets - and a potential push to impeach President Trump.4 However, this is not the worst of it. As November approaches, through a tumultuous summer full of headline risks, President Trump may double-down on his doctrine of "maximum pressure" - which objectively succeeded in the case of North Korea. This could produce more aggressive rhetoric and policy in the ongoing trade skirmish with China, further sanctions against Iran, and tensions with Russia. Table 1Protectionism: Upcoming Dates To Watch President Trump would not be the first U.S. president to seek relevance abroad, although he may be the earliest, and potentially the lamest, lame duck president in recent U.S. history.5 As such, the real risk is not the Democrats taking over the House, but rather how the Trump administration reacts to a sudden loss of legislative initiative. While a Democratic House would dramatically increase domestic political constraints on President Trump, there are few constitutional constraints on U.S. presidents when it comes to foreign policy. As such, the midterm election is market relevant, but not because Democratic Party control will be able to impact domestic policy. Investors should remember why markets cheered President Trump in the first place: Chart 1Trump: A Boon For Main Street And Wall Street Chart 2Easy Fiscal + Tight Money = Buy SPX Deregulation: Business confidence soared even before Donald Trump was inaugurated as president, especially among small businesses, while regulatory worries melted away (Chart 1).6 The executive branch controls the regulatory process, which means that the Democratic takeover of the House of Representatives, or even the Senate, will have little impact. Tax cuts: Fears that the Democrats will be able to reverse the tax cuts are overstated. Without a veto-proof majority in both chambers of Congress - two-thirds of the seats - the Democrats cannot regain legislative initiative or reverse President Trump's accomplishments. Table 2ADXY Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Table 2BSPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Fiscal policy: Markets are currently pricing in a rare mix of tightening monetary policy and stimulative fiscal policy, a bullish combination (Chart 2) that tends to boost both equities and the dollar (Table 2). While there is no need for fiscal profligacy at the current point in the cycle (Chart 3), we would think that investors would recoil at any sign of fiscal conservativism. But looking for austerity within the current Democratic Party - whose official party platform calls for universal health coverage, for example - is a mistake. Chart 3An Odd Time For Fiscal Profligacy As such, the Democratic Party's control of the House - or even the Senate, given that a filibuster-proof majority is out of reach in 2018 - is unlikely to reverse the policy and regulatory backdrop that has been so beneficial for equities over the past 18 months. Instead, the risks are twofold. First, that President Trump reacts to the coming electoral bloodbath well ahead of November with aggressive foreign and trade policy that plays to his base. Second, that markets begin pricing in impeachment risk. Although we do not think that impeachment would have a major or direct impact on earnings and the real economy, it could add to volatility and could imply higher odds of a Democratic win in 2020 (think Gerald Ford). This would present a scenario in which the Democrats would be more likely to reverse Trump's policies in 2020, thus increasing uncertainty. As such impeachment could start being priced in well ahead of the November election. We would therefore expect midterm-related volatility to rise before the election. The election itself could likely be a time to buy risk assets, provided that fundamentals, the macro backdrop, and geopolitical risks all combine into a bullish signal, as long as President Trump makes an effort to move to the middle and work with either a split Congress, or even a potentially Democratic-led legislature. These are all sources of uncertainty and therefore provide plenty of reasons for the markets to fret ahead of the election. Who Will Win The Midterm Election? It is too early to have a high conviction view on the midterm election, which is still over six months away. Betting markets give Democrats roughly 70% probability of winning the House and just 40% of winning the Senate (Chart 4). We roughly agree with those odds, but would give the Democrats a lower chance of winning the House and a slightly higher chance of winning the Senate. There are broadly five reasons why the Democratic Party has a very good chance of winning the House of Representatives in November: Chart 4GOP Odds Have Fallen, But Stabilized Chart 5GOP Trails In Polls, But Still Close Polling: The generic congressional ballot (Chart 5) has the Democrats up 6.7% on the Republicans. The generic ballot has a decent predictive track record. Basically, the party that is up tends to perform well in the election. Meanwhile, Trump's approval rating, despite its recent recovery in support, remains at the lower end of presidential approval ratings ahead of midterm elections, predicting a 35-seat loss for Republicans in the House (Chart 6). On the whole, the Democrats' polling advantage is modest-to-strong. True, it could unravel over the summer. But at current levels, it is still a respectable advantage. Chart 6Republican Presidents And Midterm Results Retirements: Republicans in the House and the Senate are retiring at an alarming pace, one never seen in the modern political context (Chart 7). We cannot overstate how important this is, especially given that there has been a 20% swing against non-incumbent Republicans in deeply conservative districts that have held special elections thus far (Table 3). Most worrying for the GOP is that, of the 42 Republicans who have announced retirement, 18 sit in seats that are not "solidly" held by the GOP.7 These are seats that only elected the Republican candidate by an average of at most 5% more than the overall Republican vote in the 2012 and 2016 election. Chart 7GOP Retirements Are Unprecedented Table 32017 Special Elections Are Ominous For The GOP History: Of the 18 midterm elections since World War II, the sitting president's party only retained congressional control four times (Chart 8). The only president to win congressional control during the midterm election was Bush Jr., an election that was held a year after the September 11 terrorist attack (i.e., an exception). Americans like checks and balances and abhor hubris. Redistricting: Gerrymandering - politically motivated redrawing of district electoral maps - has mainly favored Republicans over the past decade.8 It has also significantly reduced the number of competitive districts available to electoral swings (Chart 9). Recently, however, the Pennsylvania state Supreme Court invoked the state constitution and struck down the congressional map that favored the GOP. The Supreme Court of the U.S. then refused an emergency request from Pennsylvania Republicans to block the new, non-partisan map drawn by the state court. This decision followed several decisions in 2016-17 that saw congressional maps in North Carolina, Virginia, Texas, Wisconsin, and Alabama either thrown out or questioned. The changes will help the Democrats at the margin, potentially making the difference between a majority and a minority position in the House. Chart 8Trump Is ##br##Fighting History Chart 9Gerrymandering Reduces##br## Competitive House Seats Momentum: Shouldn't a strong economy and sub-4% unemployment rate help the Republicans in November? The simple answer is not much. Just as a strong economy and a 4.7% unemployment rate did not help the incumbent party and its candidate Secretary Hillary Clinton fend off the inexperienced challenger, Donald Trump, in 2016. Simply put, economics is relative and partisan. While Republican voters suddenly became very happy about the economy after Trump's election - having been miserable merely days before- it is now the Democrats who believe that the economy is in a downward spiral (Chart 10). It is therefore difficult to see how the current economic performance makes enough of a difference to swing voters away from the trends we describe above. Further supporting this view is the fact that economic issues, broadly defined, are declining in terms of relevance in the upcoming election (Chart 11).9 Chart 10Politics Trumps Data! Chart 11It's Not Necessarily The Economy The trend is clear: Republicans are in trouble when it comes to the House of Representatives (Chart 12). Democrats need to win only 25 seats in November and there are now 29 Republicans representing seats that The Cook Political Report, the expert political analysis shop when it comes to predicting individual House races, classifies as "toss-up or worse." Our call, at this point, is that the Democrats have a 60% probability of winning the House of Representatives. We hesitate to set our odds at the higher end, near where the betting markets are pricing it, as there is still a long time until the election. In addition, the Democrats' lead in the generic congressional ballot has halved from 13% since December. What about the Senate? We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.10 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. Our model is a work in progress and we will update our clients as it develops. The results of our "beta" model, expressed as a margin of victory by the GOP candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate (Chart 13).11 This is astonishing given that the Democrats are defending nine seats in "red states," whereas Republicans are only defending one seat in a "blue state" (Nevada). Basically, our model predicts that Republicans would lose Nevada and Tennessee. Meanwhile, of the five Senate races that are ranked as "toss ups" and that are currently held by Democrats, our model predicts that Republicans will only win Indiana. Given that current polling is highly unreliable, we would take all predictions of our model with a healthy dose of skepticism. Nonetheless, the results are surprisingly bullish for the Democrats. Chart 12The Number Of "At-Risk" GOP Seats Has Doubled Chart 13BCA Senate Model Says: Election Is Too Close To Call Our call, at this point, is that the Democrats have a 45% probability of winning the Senate; essentially the election is too close to call. This is higher than where the betting markets are pricing the election and an astonishing turnaround from 12 months ago, when most forecasts ignored Democrat chances in the Senate given how unfavorable the math was for their odds of winning. What does it all mean for the markets? Chart 14Midterm Elections Are A Boon For The S&P 500... Chart 15...But Really, It's All About The Fed Generally speaking, the market has performed very well following midterm elections during a Republican presidency (Chart 14). At closer inspection, however, it appears that this may have been because monetary policy has almost always been easy during these periods (Chart 15). As fate would have it, Republican presidents have been generally blessed with easy monetary policy. As such, we do not think that investors should take anything from this data. Table 4Democratic Primaries To Watch Rather than rely on uncertain empirical results, we would simply point out that the run-up to the midterm election, this coming summer, looks packed with geopolitical risks and uncertainty. President Trump is facing a potential defeat in Congress and will want to ensure that his base turns out for the election. This could mean doubling down on those parts of his policy agenda where the constitutional constraints are the weakest: foreign and trade policy. This is a recipe for more volatility. The midterm election is therefore a catalyst, if not the source, of near-term volatility. Furthermore, investors should carefully observe the results of key Democratic primary races (Table 4). Any sign that the Democratic Party is fielding left-wing candidates, as opposed to centrists, would have two implications. On one hand, it would lower our odds of the Democrats winning the House and definitely the Senate. On the other hand, it would increase the odds that the U.S. will have a political paradigm shift over the next electoral cycle. If the Democrats swing hard to the left and win the midterm election, the implications for investors would be hard to overstate. As a point of reference, investors should remember that Republicans swung hard to the right in 2010-14, presaging the rise of Trump. Yet these Republican victories took place in the face of long-term demographic and social headwinds, whereas comparable Democratic victories today would take place in the face of long-term demographic and social tailwinds. American policy can shift harder to the left over the coming decade than it did to the right over the past eight years.12 As Charts 16 and 17 show, the U.S. is at "peak inequality." As the example of France illustrates, income inequality does not necessarily go up. In the early 1960s, France had a larger share of the national income apportioned to the wealthy than the U.S. does today. Since then, it has fallen. In other words, societal decisions on wealth redistribution vary over time. The concern for investors would be if any Democratic party move to the far left is rewarded at the polls in November. If this were to happen, it would be appropriate to begin pricing in a significant decline in the share of national income that goes to corporate profits, if not yet a decline in social unrest. As Chart 17 illustrates, a significant decline in wealth concentration in France occurred right around the late 1960s. The May 1968 revolution was one of the most paradigm-shifting moments in France's post-World War II history. If the markets begin pricing in anything close to this degree of change in the U.S., the S&P 500 could enter a bear market. Chart 16GOP Tax Cuts: Same Old Story Chart 17Beware May 1968 Bottom Line: Our odds of the Democrats winning the House are 60%, below market expectations. Our odds of the Democrats winning the Senate are 45%, above market expectations. While we do not think that Democratic control of Congress, or just the House, will be negative for earnings on a cyclical time horizon, we do understand why investors would price in higher volatility. First, President Trump may respond to a loss of congressional control by seeking relevance abroad through hawkish foreign and trade policy. Second, investors may sense a paradigm shift occurring in the U.S. if left-wing Democrats start winning primary races and then go on to win the House. Is Impeachment A Risk? In a report titled Break Glass In Case Of Impeachment, we argued that investors should fade impeachment-related volatility.13 Equity markets are driven by earnings. As such, there has to be a direct relationship between political volatility and company earnings. Impeachment has rarely produced such a link. Chart 18 looks at market performance during the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Of the three, the Teapot Dome scandal did not result in impeachment proceedings, but only because President Harding died in office in 1923 - and neither his death nor the unfolding scandal prevented the stock market from "roaring" through the mid-1920s.14 Chart 18AVolatility Amid Three U.S. Scandals Chart 18BEquities Amid Three U.S. Scandals The market reaction to the Lewinsky Affair was also highly muted. Like the Teapot Dome incident, it occurred amidst one of the greatest bull markets in U.S. history. Of course, U.S. equities did fall 19% mid-way through the Clinton impeachment process, but this was more due to global risk factors than domestic politics. Watergate appears to have affected both equity markets and volatility. The S&P 500 fell 39% from February 7, 1973 - when the Senate established a select committee to investigate Watergate - until Nixon's resignation on August 9, 1974. That said, the scandal alone did not cause the correction; rather, it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, and a massive insurance fraud scandal. Writing in the summer of 1973, BCA remarked that while a speculative, "Watergate-inspired," attack on the dollar further contributed to some short-term capital outflow, but that the macro-fundamentals of the economy would ultimately persevere. Would today play out more like Teapot and Clinton, or Nixon? It will depend on the fundamentals. In the 1920s and the 1990s, fundamentals were solid and thus politics could not dent the ongoing bull market. In the early 1970s, macro fundamentals were terrible and thus politics accentuated the decline in the bear market. One thing that impeachment would not change, however, is policy. The U.S. is not Brazil. Impeachment will not lead to a 180 degree change in policy outcomes. Vice President Mike Pence is a Republican and is as pro-business as Trump. Given that the aggressive trade policy towards China has both public and establishment support, we would not expect any relief on the protectionism front. However, there would be a lot less tweeting, insults, and erratic foreign policy rhetoric aimed at both allies and rivals. The "maximum pressure" doctrine would likely be replaced by a more traditional policy of carrots and sticks. Most notably, we think this would minimize the risk of a proxy war with Iran in the Middle East. How likely is impeachment once Democrats take over the House? It depends. If President Trump fires Department of Justice Special Counsel Robert Mueller, the Democrats in the House of Representatives may get enough votes to impeach President Trump even without a House takeover! The question is whether impeachment would matter. As we outlined in our special report, impeachment is a political, not a legal, process. As such, the House of Representatives has a low bar for impeachment. It can essentially impeach the U.S. president for anything, including a debatable claim that he obstructed justice. The real question is whether the Senate would convict. To do so, the Senate must hold a trial and vote on whether to remove the president from office by a two-thirds majority (67 votes). Even if Democrats win the Senate, they would need over 15 Republican Senators to join them in removing a sitting U.S. president from office, which has never been done in American history. This could happen, but it would require the American public, particularly Republicans, to lose faith in President Trump. In particular, we have been advising clients to focus on Republican voters' support for Trump. If it dips well below 70%, we suspect that Senators could start switching sides. We are currently nowhere near these levels (Chart 19). What could change these levels of support? The Mueller special investigation is a big risk to President Trump even if one thinks that the charge of collusion with Russia is unfounded. President Bill Clinton was similarly investigated by an independent special investigator, Kenneth Starr. Starr initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky, an issue completely unrelated to the original investigation. In other words, once independent investigators start digging, there is no telling what skeletons they will exhume. We do not intend to "prosecute" claims against President Trump in this or any future report. But we can also envision a scenario where the Mueller investigation reveals enough evidence of malfeasance to shake GOP voter confidence in President Trump, leading to a potential scenario where he is removed from power. Would the market care at this point? We think the answer is yes. While removal of a U.S. president has no impact on earnings, it could have an impact on social stability. Political polarization is at its highest levels in the U.S. (Chart 20), and roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being" (Chart 21). Chart 19Impeachment: Not A Risk (Yet) Chart 20Polarization, As Inequality, Remains At Record Highs Chart 21"A Threat To The Nation's Well-Being?" Really?! We would fade any risk of a widespread, Red State rebellion. Since a change in Republican opinion is required for Senators to convict Trump, most of Trump's supporters will have already lost faith in him by the time he is removed from office. As we outlined in our Strategic Outlook, we doubt that many Trump voters would risk social unrest to defend their champion.15 Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). But convincing the markets may take time, and any sign of even minimal right-wing terrorism could create volatility and drawdowns. Bottom Line: Impeachment remains a headline risk to the markets. We continue to believe that impeachment will merely accentuate the impact of fundamentals on risk assets. However, fundamentals themselves are starting to look vulnerable, at least on a tactical horizon. As such, we are entering a six-month period where geopolitical, trade, and domestic political risks could pose headwinds to U.S. risk assets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017; "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 President Clinton launched the largest NATO military operation at the time against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops into Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. Less dramatic, but still notable examples, are President George W. Bush ordering the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006, and President Barack Obama negotiating the Iranian nuclear deal after losing the Senate (and hence the entire Congress) to the Republicans in 2014. 6 Please see BCA Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism!" dated November 8, 2017, available at gps.bcaresearch.com. 7 We use The Cook Political Report methodology for reporting the characteristic of House seats. Seats are split into "toss-up or worse," "likely/lean," and "solid" based on their Partisan Voter Index (PVI) score. The Cook PVI measures how each district performs at the presidential level compared to the nation as a whole. A district with a D+2 PVI voted an average of two points more Democratic than the nation did as a whole in the last two presidential elections (2012 and 2016 for current PVI rating). The Cook Political Report defines a "swing seat" as one that falls between D+5 and R+5. A "solid Republican" seat would therefore be any seat with a PVI of R+5 or higher. A "solid Democrat" seat would therefore be any seat with a PVI of D+5 or greater. 8 This is not to say that Democrats have not redistricted for partisan reasons. California was famously redistricted in the 1980s. Most recently, former Maryland Governor Martin O'Malley admitted, during a court deposition, that he redrew the state's district borders specifically to increase the Democratic congressional majority in the state. Please see Amber Phillips, "Maryland's redistricting case reminds us: Both parties gerrymander. A lot." The Washington Post, dated March 28, 2018, available at washingtonpost.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "As Good As It Gets?" dated January 29, 2018, available at usis.bcaresearch.com. 10 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincidence index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 11 The U.S. Vice President, Republican Mike Pence, would cast the deciding vote in case of a 50-50 tie and therefore the Democrats require a pickup of two seats. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 14 "Teapot Dome" was for decades the largest corruption scandal in U.S. history. It involved President Warren G. Harding, his Secretary of the Interior, other officials, and a number of oil companies that were given extremely favorable leases to drill oil in federal land in Wyoming. Investigations and prosecutions lasted through 1927. 15 Please see BCA Geopolitical Strategy Strategic Outlook, "BCA Geopolitical Strategy 2017 Report Card," dated December 13, 2017, available at gps.bcaresearch.com.
Highlights An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth (ceteris paribus). Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat, but with a short leash. Feature Trade frictions between China and the U.S. continue to dominate the headlines of the financial press. The most significant potential escalation in the conflict came two weeks ago, when President Trump instructed the U.S. Trade Representative to consider an additional $100 billion in tariffs on imports from China (on top of the initially proposed $50 billion). For investors, the possibility of a full-blown trade war between China and the U.S. and its implications for financial markets remains the "question that won't go away". Given that negotiations between trade representatives of both countries are highly active, the President's public suggestion that an additional heavy salvo of tariffs may be levied appears to be a clear case of economic saber-rattling. Still, investors cannot neglect the odds that such a scenario does indeed materialize, and in this week's report we revisit some of our previous work on the impact of proposed U.S. tariffs on Chinese economic growth. We also outline the (difficult) policy options available to Chinese policymakers, update investors on the state of China's business cycle, and reiterate our recommended investment strategy of staying overweight Chinese ex-tech stocks (with a short leash). The Impact Of Proposed Tariffs On Growth, Part II Chart 1150$ Billion In Import Tariffs Would Seriously ##br##Harm Chinese Export Growth We presented our framework for modeling the impact of U.S. import tariffs on overall Chinese export growth in our March 28 Weekly Report.1 Our approach suggested that the original $50 billion in proposed tariffs would cause China's total export growth to decelerate about 2%, which would work to counteract the acceleration in underlying export growth that we would normally expect over the coming months given the pace of the global demand. Chart 1 updates this framework assuming a total of $150 billion in tariffs. While overall nominal export growth would not contract outright as a result of the tariff imposition, it would decelerate materially from our estimate of its underlying rate (currently 10%). There are good odds that Trump's suggestion of an additional $100 billion in tariffs against China was merely a negotiating tactic, and it is clear that China has a strong incentive to agree to a trade deal with the U.S. that will prevent the scenario depicted in Chart 1 from taking place. But were it to, it would represent a significant threat to China's cyclical economic momentum, in a manner that would surpass the direct contribution to Chinese growth from the external sector. Charts 2 and 3 explain why. Chart 2 first presents an annual time series of the net export (NX) contribution to Chinese real GDP growth, relative to final consumption expenditure and gross capital formation. Investors might initially react to this chart by concluding that a significant deceleration in export growth would have a minimal impact on the Chinese economy, since the net contribution to growth from the external sector has typically been small relative to the other expenditure categories. Chart 2Net Exports Are Not A Huge##br## Direct Contributor To Growth... Chart 3...But The Export Sector Is Highly ##br## Investment-Intensive However, this perspective misses two important elements of the Chinese economy that are crucial to understand: China's import demand is strongly tied to the export channel, given that roughly half of Chinese imports are commodity-oriented. This means that Chinese import growth would also suffer from a sudden hit to U.S. exports, which would reverberate the shock to China's trading partners (and back again to China). In short, the imposition of major U.S. tariffs on imports from China would cause a negative feedback loop for China and its key trading partners. Abstracting from the global financial crisis, Chart 3 highlights that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent investment. This underscores that an important portion of China's gross capital formation, which is a significant contributor to the Chinese economy, is driven by the export sector. Based on the relationship shown in Chart 3, and the historical relationship between nominal exports and the real contribution from net exports, the scenario depicted in Chart 1 could cause the contribution to growth from Chinese investment to fall 0.5-0.6 percentage points, which could push real GDP growth to or below 6% if consumption remained constant. While we have not focused on real GDP growth as an accurate measure of Chinese economic activity, a deceleration of that magnitude would be on par with what occurred in 2011-2012, when Chinese stocks and related financial assets fared quite poorly. Bottom Line: An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth. Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. China's Policy Options Our analysis above did not incorporate a stimulative response from Chinese policymakers, which we would certainly expect if China experienced a large shock to its export sector. Table 1 presents a brief list of policy actions that the Chinese government could employ in response; some are narrowly focused on the export channel, and some would impact the economy more broadly. Table 1No Easy Cure-Alls To Ease The Impact Of Tariffs Our assumption is that policymakers will initially choose more focused policies and will refrain from broad-based stimulus unless the impact of the export sector shock is expected to much more significant than is currently the case. This is particularly true given that Table 1 highlights the difficulty facing Chinese policymakers, in that there are significant drawbacks associated with any of the policies described. Given that the proposed import tariffs will primarily affect firms manufacturing goods for export to the U.S., the most focused policies would be to provide some offsetting form of stimulus to the manufacturing sector and to depreciate the RMB versus the U.S. dollar. In our view, manufacturing sector-specific stimulus is the most likely to occur of any policies described in Table 1: the drawbacks are primarily structural in nature, and China has already announced a slight reduction in the tax rate for manufacturing industries as part of a series of changes to the VAT regime. We expect to see more announcements in this vein over the coming months. Materially depreciating the RMB vs the U.S. dollar, however, is quite unlikely to occur as a stimulative response, as it would very likely inflame trade tension with the U.S. Chinese authorities may use threats of backtracking on the non-trivial appreciation in CNYUSD over the past year during talks with the U.S., but we doubt that authorities would actually go ahead with this barring a complete breakdown in negotiations. Depreciating versus the euro is similarly problematic. Chart 4 highlights that the RMB has barely risen at all versus the euro over the past year, implying that a meaningful depreciation would likely anger euro area policymakers, especially given that the trade-weighted euro has already risen nearly 10% over the past year. Instead, Chart 5 highlights the most likely route if China chooses to use the RMB as a relief valve: a depreciation against Japan, Korea, Vietnam, and India. China's combined export weight to these countries is meaningful, and the chart shows that there is depreciation potential: a weighted RMB index versus these currencies has risen about 8% in the past 12 months. Chart 4The RMB Has Not Appreciated ##br##Against The Euro Chart 5Room To Depreciate Against A ##br##Basket Of Asian Currencies We will revisit the remaining policies listed in Table 1 if the U.S. does indeed follow through with a second round of significant tariffs against Chinese imports, or if the economic effect of the first round proves to be more significant than we expect. From a bigger picture perspective, the potential for broader stimulus from Chinese authorities (in response to a more impactful shock) raises the interesting possibility of another economic mini cycle in China. While the need to stimulate broadly, were it to occur, would clearly imply that the economy would first be weakening, investors should remember that China's economy ultimately accelerated meaningfully in response to the last episode of material fiscal & monetary easing. We presented our framework for tracking the end of China's current mini-cycle in our October 12 Weekly Report,2 and argued that a benign, controlled deceleration was the most likely outcome (Chart 6). In our view the economic data has validated this call over the past six months, and we do not see any reason yet to deviate from it (see next section below). But a severe export shock followed by a burst of economic stimulus would clearly alter our expectations for China's business cycle dynamics, and would also create some exciting investment opportunities for investors (both on the downside and the upside). While the odds of this scenario are not currently probable, we raise the possibility because of the significance that another cycle would have for global investor sentiment and the returns from Chinese financial assets. Chart 6A Stylized View Of China's Recent "Mini-Cycle" Bottom Line: Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. Abstracting From Trade, China Continues To Slow As noted above, we have been flagging a deceleration in China's industrial sector since early-October. Table 2 is an updated version of a table that we presented in our March 7 Weekly Report,3 which shows recent data points for several series that we have identified as having leading properties for the Chinese business cycle, as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, and how long this has been the case. While we do not yet have all of the March components of our BCA Li Keqiang leading indicator, the four that are available all declined in March from February, suggesting that the ongoing economic slowdown continues. Table 2Key Chinese Data Do Not Signal A Broad Acceleration The table does highlight, however, two relatively positive developments: the Bloomberg Li Keqiang index was materially higher on average in January and February than it was in the two months prior, and now both the official and Caixin manufacturing PMIs are above their 12-month moving average, with the latter having been so for 4 months in a row. An average of the two measures, along with its 12-month moving average, in shown in Chart 7. Are these budding signs of a durable upturn in China's industrial sector? We do not take a dogmatic approach to forecasting China's cyclical trajectory, and will be monitoring this possibility over the coming months. But in our current judgement, the answer is no. The January pop in Bloomberg Li Keqiang index reflects two separate factors: a jump in the annual growth of rail cargo volume in January (which subsequently unwound in February), as well as strong growth in electricity production on average in January and February (Chart 8). Normally this would be an encouraging sign for China's economy, but when connected with the countertrend move in the manufacturing PMIs and the sharp, unsustainable rise in February's export growth, a pattern begins to emerge. Chart 7A Modest Tick Up In China's ##br##Manufacturing PMIs Chart 8The Li Keqiang Index: ##br##A Brief, Countertrend Move While far from conclusive, it would appear that China experienced a very sudden burst of goods production for the purposes of export. Given that this is occurring in the context of considerable trade frictions and the eventual imposition of import tariffs, and against the backdrop of strong but steady (and possibly peaking) global demand, it is conceivable that China's exporters are attempting to front-load shipments for the year before these tariffs take effect. Although a February surge is visible in Chinese export growth to several countries (not just the U.S.), and undoubtedly some of the effect is due to the timing of the Chinese new year, it is possible that Chinese exporters are acting in anticipation of possible additional tariffs on other countries or global industries that China acts as a supplier to. We noted above that the imposition of the first round of U.S. tariffs will likely be enough to arrest any acceleration in overall Chinese export growth, with a second round likely to cause a downward change in trend. Thus, to us, it is difficult to see an export-driven catalyst for China's industrial sector continuing over the coming months. On the import side, the data has also been more positive than we would have expected, given the close link between import growth and the Li Keqiang index (Chart 9). Part of this deviation may be accounted for by unsustainable export growth, given the typically strong link between import and export growth in highly trade-oriented economies. Interestingly, Chart 10 highlights that the flat trend in import growth appears to be supported by an uptrend in manufactured products, whereas the trend of primary products imports is much more consistent with what our indicators would suggest. For now, we are sticking with the signal given by the latter, since it has historically been a more reliable predictor of whether overall future import growth will be growing at an above-trend pace. But as we stated above, our view of a benign slowdown in China is empirically-based, and we will continue to monitor the data for signs that the external sector of China's economy warrants a change in our slowdown view. Chart 9Import Growth Has Held Up##br## Better Than We Expected... Chart 10...But Commodity Imports Suggest##br## Broad Import Growth Will Weaken Bottom Line: A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Investment Implications We noted in our March 28 Weekly Report that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks.1 We recommended in that report that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. This recommendation stands, although it is notable that the relative performance of Chinese ex-tech shares (versus global) remains comfortably above its 200-day moving average (Chart 11). Chinese tech stocks, on the other hand, have sold off meaningfully over the past month (Chart 11 panel 2) due in part to the tech oriented nature of the U.S.' trade action. We advised investors to reduce their exposure to the tech sector in our February 15 Weekly Report,4 based on elevated earnings momentum and very rich valuation. Conversely, pricing also appears to be at the root of resilient ex-tech relative performance: Chart 12 shows that the 12-month forward earnings yield versus U.S. 10-year Treasurys is considerably higher for Chinese ex-tech companies than in developed or other emerging equity markets. This reinforces an argument that we have made in previous reports, which is that investors should have a high threshold for reducing exposure to China. Chart 11Chinese Ex-Tech Stocks ##br##Are Doing Fine, For Now... Chart 12...Supported By A Sizeable ##br##Risk Premium The key question is therefore whether the probable shock to Chinese export growth coupled with the ongoing slowdown in the industrial sector is significant enough to pre-emptively downgrade Chinese stocks. Our answer to this question remains "no", since investors still do not have the requisite visibility on the magnitude of the hit to exports and the likely policy response. Until this information emerges, we continue to recommend that investors stay overweight Chinese ex-tech stocks unless a technical breakdown emerges, and to watch for additional updates on this issue from BCA's China Investment Strategy service over the coming weeks and months. Bottom Line: Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat. Our downgrade watch remains in effect, and we are likely to advise a reduction in exposure in response to a technical breakdown. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. 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-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 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, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... Chart 11...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Chart 16Likely No Majority In Congress Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Chart 18Mexico's Rising Political Plurality Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Chart 20A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Chart 22Abe Holding At Koizumi's Levels Of Support More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.
Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling OverTable 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.
Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Feature Japan's economic experience in the post bubble era is often described as a fate to avoid at all costs. We would like to turn this common notion on its head. Rather than something to avoid, Japan's post bubble experience is a fate that other major economies should actively try to emulate, at least in parts. This report focusses on three specific lessons for European investors. Japan's so-called 'lost decades' describe the weak growth in its nominal GDP since the mid-1990s. But this emphasis on aggregate nominal income is grossly misleading. Standards of living do not depend on nominal GDP. What matters is real GDP per head combined with the absence of extreme income inequality. Real income must grow and this growth must benefit the majority, rather than a small minority. Since the late 1990s, the growth in Japan's real GDP per head has outperformed every other major economy (Chart Of The Week). And unlike other major economies, income inequality in Japan has not increased, remaining amongst the lowest in the developed world (Chart I-2). This is not surprising. Credit booms inflate bubbles in financial assets, which exacerbate income and wealth inequalities. Chart Of The WeekJapan Has Outperformed Everybody Chart I-2Income Inequality In Japan Has Not Increased Admittedly, the government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan's real growth has come entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements is sustainable. Genuine Price Stability: Something To Celebrate, Not Fear Japanese consumer prices are at the same level today as they were in 1992, meaning that Japan has experienced genuine price stability for two and a half decades (Chart I-3). But this is neither new, nor alarming - Britain enjoyed genuine price stability for two and a half centuries! At the height of the British Empire in 1914, consumer prices were little different to where they stood at the end of the English Civil War in 1651 (Chart I-4). Chart I-3Japan Has Experienced Genuine Price ##br## Stability For Two And A Half Decades... Chart I-4...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! Nevertheless, central banks continue with the deception that price stability means an inflation rate of 2%. This is clearly nonsense. Think about it - if prices rise by 2% a year, then your money will lose a quarter of its purchasing power every decade. And after a typical working life, your money will have lost two-thirds of its value.1 How exactly does that qualify as price stability?2 Still, we frequently hear a strong counterargument - in a highly indebted economy, inflation and growth in nominal GDP do matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% rather than at zero; and nominal GDP growth at 3.5% rather than at 1.5%. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point target. As we explained a while back in The Case Against Helicopters, inflation is a non-linear phenomenon which is extremely difficult, if not impossible, to point target.3 Look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. Chart I-5The Money Multiplier Is Non-Linear M is non-linear because the commercial banking system money multiplier - the ratio of loans to bank reserves - is non-linear. At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible (Chart I-5). Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At this point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. What is the Japanese lesson for Europeans? Simply that just like the BoJ, the ECB will keep moving the 2% inflation goalpost further and further into the future, as it realises the impossibility of achieving and sustaining the 2% point target. So even with inflation in the 1-2% channel, the ECB will create a loophole to exit NIRP and ZIRP very soon after it exits QE. This will structurally support the euro. Do Not Own Banks For The Long Term (Or Now) Japanese financial sector profits stand at less than half their peak level in 1990. For euro area financial sector profits which peaked in 2007, the interesting thing is that they are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth through the next 17 years (Chart I-6). Chart I-6Euro Area Financial Profits May Experience No Sustained Growth In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage - the amount of equity held against the balance sheet. More stringent European regulation will make this a headwind too. Banks will have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin - the difference between rates received on loans and rates paid on deposits, effectively a function of the yield curve slope. However, this is a cyclical driver, and as explained last week in Market Turbulence: What Lies Ahead? this driver is unlikely to be positive in the coming months.4 What is the Japanese lesson for Europeans? Simply that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play during periodic strong countertrend rallies, albeit now is not the time for such a cyclical play. A Surge In Female Participation Chart I-7Sales Of Personal Products Have Boomed Over the past twenty years, Japanese sales of skin cosmetics and beauty products have almost tripled (Chart I-7). This has helped the personal products sector to outperform very strongly. The personal products sector is dominated by female spending. So it is significant that in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has held at 85%. Therefore, all of the growth in the Japanese labour force through the past twenty years has come from women. Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has held at 78%. So just as in Japan, all of the growth in European labour force participation through the past twenty years has come from women (Chart I-8). But for the ultimate end-point in the European trend, look to the Scandinavian countries which have had generous parental leave policies since the 1970s. As a result, labour force participation for Swedish women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force. What is the Japanese lesson for Europeans? While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled. Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17-year lag (Chart I-9). If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years. Stay overweight the European personal products sector. Chart I-8A Surge In Female Participation Chart I-9Personal Products Profits Set To Grow Very Strongly Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming you work for 50 years. 2 Admittedly, measured inflation probably overstates true inflation. However, estimates put this measurement error at no more than 0.3-0.5 percentage points. 3 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5 2016 and available at eis.bcaresearch.com 4 Please see the European Investment Strategy Weekly Report 'Market Turbulence: What Lies Ahead?' published on March 29 2018 and available at eis.bcaresearch.com Fractal Trading Model* This week’s trade recommendation is to go long the Australian dollar versus the Norwegian krone. The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations