Euro Area
Dear Client, Along with this brief Weekly Report, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. Marko argues that the U.S. is vulnerable to serious socio-political instability by the 2020 election, as a result of the widening gulf between elites and the rest. Trump, thus far, seems unlikely to bridge this gap. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlight U.S. growth will accelerate over the remainder of the year, thanks to easier financial conditions. This will force the Federal Reserve to raise rates more than the market is currently discounting. In contrast, the BoJ and the ECB will remain on hold. The net result would be a stronger dollar. Solid Chinese growth will support commodity prices. Stay overweight global equities over a cyclical horizon of 12 months. Feature U.S. Growth Will Surprise On The Upside I have been meeting clients in Asia over the past week. The ongoing decline in Treasury yields - the 10-year yield hit a 7-month low of 2.14% this week - was a frequent topic of conversation. Investors are becoming increasingly convinced that the U.S. economy is running out of steam. The OIS curve is pricing in only 48 basis points of rate hikes over the next 12 months. Since a June rate increase is now largely seen as a done deal, the market is essentially saying the Fed will abandon its tightening cycle later this year. We think that's too early. The U.S. economy may not be on fire, but it is hardly floundering. The Blue Chip consensus estimate for Q2 growth stands at 3.1%. The Atlanta Fed's GDPNow model is pointing to growth of 3.4%. There is little reason to think that growth will slow substantially later this year. Financial conditions have eased significantly over the past few months thanks to a weaker dollar, falling bond yields, narrower credit spreads, and higher equity prices (Chart 1). Our research has shown that GDP growth tends to react to changes in financial conditions with a lag of around 6-to-9 months (Chart 2). This means demand growth is likely to strengthen, not weaken, over the remainder of the year. Chart 1Financial Conditions Have Been Easing... Chart 2...Which Bodes Well For Growth Running Out Of Slack If demand growth does accelerate, does the U.S. economy have the supply capacity to fully accommodate it? We do not think so. The headline unemployment rate fell to a 16-year low of 4.3% in May. It is now half a percentage point below the Fed's estimate of full employment. The broader U-6 rate, which includes marginally-attached workers and those working part-time purely for economic reasons, dropped to 8.4%, essentially completing the roundtrip to where it was before the recession (Chart 3). Chart 3A Tight Labor Market Chart 4Wage Growth Is In An Uptrend Chart 5Wage Gains Are Broad Based Contrary to popular perception, wages are rising. Looking across the various official wage indices that are published on a regular basis, the underlying trend in wage growth has accelerated from 1.2% in 2010 to 2.4% (Chart 4). The acceleration in wage growth has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 5). Wage Growth: No Mystery Here Granted, wage growth is still about a percentage point lower than it was before the recession, but that can be explained by slower productivity growth and lower long-term inflation expectations (Chart 6). Real unit labor costs, which take both factors into account, are rising at a faster pace than in 2007 and close to the pace in 2000 (Chart 7). Chart 6A Secular Downtrend In Productivity Growth ##br##And Inflation Expectations Chart 7Rising Real Unit Labor Costs: ##br##A Case Of Deja-Vu Looking out, wage growth is likely to accelerate further. The evidence strongly suggests that the Phillips curve has a "kink" at an unemployment rate of around 5% (Chart 8). In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 6% to 4% does. The Cost Of Waiting One might argue that the Fed can afford to take a "wait and see" approach to raising rates. There is some merit to this view, but it can be taken too far. If the Fed is to have any hope of achieving a soft landing for the economy, it needs to stabilize the unemployment rate at a level close to NAIRU. This may be possible if the unemployment rate is near 4%, but it would be difficult to pull off if the rate slips much below that level. Trying to stabilize the unemployment rate when it has already fallen well below its full employment level means accepting a permanently overheated economy. A standard "expectations-augmented" Phillips curve says that this is not possible to accomplish without accepting persistently rising inflation. If the Fed did find itself in a situation where the economy were overheating, it would have no choice but to jack up rates in order push the unemployment rate to a higher level. Unfortunately, the evidence suggests that once the unemployment rate starts rising, it keeps rising. Indeed, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 9). Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The inescapable fact is that modern economies contain numerous feedback loops. When unemployment is falling, this generates a virtuous cycle where rising employment boosts income and confidence, leading to more spending and even lower unemployment. The exact opposite happens when unemployment starts rising. History suggests that trying to raise the unemployment rate by just a little bit is like trying to get a little bit pregnant. It's simply impossible to pull off. The implication is that the Fed will not only raise rates in line with the dots, but could actually expedite the pace of rate hikes if aggregate demand accelerates later this year, as we expect. Remember, it wasn't that long ago that a typical tightening cycle entailed eight rate hikes per year. In this context, the market's expectation of less than two hikes over the next 12 months seems implausibly low. No Tightening In Japan Or Europe Chart 10Inflation Is Way Below The BoJ's Target Could other major central banks follow in the Fed's footsteps and tighten monetary policy more aggressively than what the market is currently discounting? We doubt it. Japanese inflation is nowhere close to the BOJ's 2% target (Chart 10). And even if Japanese growth surprises significantly to the upside, the first step the authorities will take is to tighten fiscal policy by raising the sales tax. Monetary tightening remains some ways off. Likewise, while the ECB might remove a few of its emergency measures, it is nowhere close to embarking on a full-fledged tightening cycle. The ECB's own research department recently put out a paper documenting that the combined unemployment and underemployment rate currently stands at 18% of the labor force across the euro area (Chart 11). This is 3.5 points above where it was in 2008. If one excludes Germany from the picture, the level of unemployment and underemployment is seven points higher than it was in 2008. This is not the stuff of which tightening cycles are made. Meanwhile, on the other side of the English Channel, the BoE must contend with the fact that growth remains underwhelming, partly due to ongoing angst about Brexit negotiations (Chart 12). Chart 12U.K. Is Lagging Its Peers EM Outlook Chart 13Positive Signs For The Chinese Housing Market... The outlook for EM currencies is a tougher call. On the one hand, a more hawkish Fed and broad-based dollar strength have usually been bad news for emerging markets, given that 80% of EM foreign-currency debt is denominated in U.S. dollars. On the other hand, stronger global growth should support commodity prices, even if the dollar is strengthening. Our energy strategists remain particularly convinced that oil prices will rise over the remainder of this year due to robust demand growth for crude and continued OPEC discipline. Strong Chinese growth should also boost metals demand, while limiting the need for further RMB weakness. Chart 13 shows that property developers have been snapping up new land at an accelerating pace. The percentage of households who intend to buy a new home has also surged to record high levels. This bodes well for construction, and by extension, commodity demand. The strong pace of growth in excavator sales - a leading indicator for capex - confirms this trend. Meanwhile, real-time measures of Chinese industrial activity such as rail freight traffic and electricity generation remain buoyant (Chart 14). This is helping to lift producer prices, which, in turn, is fueling a rebound in industrial company profits (Chart 15). And for all the talk about the government's crackdown on credit growth, the reality is that medium-to-long term lending to nonfinancial companies has actually picked up (Chart 16). Chart 14... And Positive Signs For Chinese Capex Chart 15Higher Producer Prices Boosting Profits Chart 16A Positive In China's Credit Picture Stick With Stocks... For Now In terms of global asset allocation, we continue to recommend a cyclical (12-month) overweight in equities relative to bonds. We have a slight preference for DM over EM stocks, although given some of the positive factors supporting EM economies noted above, we do not regard this as a high-conviction view. Within the DM universe, we favour higher-beta equity markets such Japan and the euro area over the U.S. (currency hedged). In the government bond space, we would underweight U.S. Treasurys, given the likelihood that the Fed will deliver more rate hikes over the coming months than the market is currently discounting. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights 'Super Thursday' June 8 brings three potentially high-impact events for financial markets: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee. Each of these events has the potential to move markets - especially currencies - abruptly in either direction. Medium-term investors should use Super Thursday and its aftermath as follows: If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. Use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position. Feature Traders will be salivating at the prospect of three potentially high-impact events for financial markets in the space of a day: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee about possible collusion between the campaign of President Donald Trump and Russian officials. This report will focus on the first two of these 'Super Thursday' events. Chart of the WeekRelative Interest Expectations Must Follow Relative Economic Performance 300-340 Conservative Seats = Short-Term Pain For The Pound Chart I-2The Pound Is Where It Was When##br## The Election Was Called The U.K. General Election result has the potential to move the pound abruptly in either direction. Therefore, it also has the potential to drive FTSE100/Eurostoxx50 relative performance which is just an inverse currency play. But treat the U.K. election result as a trading opportunity rather than as a game changer for any investment position. Theresa May admits that she called the snap election to strengthen her narrow parliamentary majority ahead of Brexit negotiations. When she called the election, the Conservatives were riding high in the polls, and markets expected May easily to achieve her aim. Reasoning that a much strengthened majority would reduce the influence of the hard Brexiters in her party, the pound rallied (Chart I-2). But as the polls have tightened, it has given back this gain. If the number of Conservative seats does not meaningfully move up from the current 330, or worse, if the result increases uncertainty, the pound is vulnerable to a further snap sell-off. A parliamentary majority requires 326 MPs, but around 320 is enough for an effective majority because Sinn Fein MPs,1 the speaker and deputy speakers do not vote. 315 might just scrape a Conservative minority government supported by its Northern Ireland Unionist allies. Hence, if the Conservatives win 300-340 seats, a knee-jerk sell-off in the pound is likely. Chart I-3The Brexit Vote Depressed The Pound Because##br## It Depressed U.K. Interest Rate Expectations If the Conservatives win well above 340 seats, the pound should knee-jerk rally - as May's effective majority would strengthen enough to marginalize the hard Brexiters. If the Conservatives win well below 300 seats, the pound might also settle higher - as this is the territory of a Labour minority government supported by the Scottish National Party and Liberal Democrats, and thereby a softer Brexit. But any major moves in the pound after the election will prove to be transient, because the over-arching driver of currencies is the interplay of interest rate expectations. Chart I-3 illustrates that last year's Brexit vote depressed the pound because the shock outcome precipitated a base rate cut and depressed expectations for Bank of England interest rate policy. In contrast to the Brexit vote, the General Election result per se will not have a lasting impact on the pound because it is unlikely to change the interest rate setting calculus for the BoE relative to other central banks. The BoE has been one of the most inert central banks when it comes to changing interest rates in either direction. Last year's emergency rate cut, forced by the shock vote for Brexit, has been the BoE's only policy rate move in 8 years! We expect the BoE to continue with its policy rate inertia because U.K. real consumption is highly correlated (inversely) to inflation. When inflation is too high, real consumption is undermined, making it difficult to hike rates; when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-4). This mirror image performance of inflation and real consumption has tied the hands of the BoE for 8 years, and will continue to do so. Chart I-4Why The Bank Of England's Hands Are Tied With the BoE's hands tied, relative interest rate expectations - and therefore the medium-term direction of the pound - will depend on the other central bank in the respective cross rate. Which brings us neatly to the ECB. The ECB Must Follow The Hard Data Years of extreme and experimental central bank intervention have left markets hyper-sensitive to the slightest change of nuance in central bank communication. We have now come to a ridiculous state of affairs where reducing two instances of the sentence "the balance of risks remain tilted to the downside" in the March 9 ECB press conference introductory statement to just one instance in the April 27 statement is regarded as de facto monetary tightening! The slightest change of nuance in central bank communication can powerfully drive markets over a timeframe of a few weeks or months. As Peter Praet, the ECB Chief Economist, warns: "After a prolonged period of exceptional monetary policy accommodation, financial markets are particularly sensitive to any perceived change in the future course of monetary policy. (Therefore) any substantial change in communication needs to be motivated by some more evidence in the hard data." On this basis, we expect the ECB to acknowledge the hard data showing euro area growth is solid and broad, and downside risks are diminishing; but that the required upward adjustment in inflation remains sluggish. For euro/dollar, a mixed message such as this might create a near-term setback of around 2%, given that it has rallied strongly in the past 65 days and is now technically overbought (see page 8). We would regard a 2% setback for the euro as a medium-term buying opportunity. As Peter Praet points out, central banks' data-dependency means that policy must follow the hard data over a timeframe of six months or longer. The Chart of the Week, Chart I-5 and Chart I-6 should make this crystal clear. Relative interest rate expectations and bond yield spreads ultimately follow relative economic performance. Chart I-5Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Chart I-6...And Inflation Differentials If, as we expect, euro area growth2 continues to perform in line with or better than the U.S. and U.K. - and inflation differentials continue to narrow - then relative interest rate expectations will also continue to converge. Even the ECB admits that its main growth worry comes not from the euro area economy itself but rather from "the considerable uncertainty surrounding the new U.S. Administration's policies." In this regard, observe that the post-Trump spike in U.S. interest rate expectations has barely unwound (Chart I-7). We think it should unwind more. And who knows, perhaps James Comey will be the immediate catalyst. Chart I-7The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound What To Do After Super Thursday Chart I-8Pound/Euro (Inversely) Drives ##br##FTSE100/Eurostoxx50 In summary, policy rate expectations - in relative terms - will structurally continue to: Get less dovish in the euro area. Remain broadly unchanged in the U.K. Get more dovish in the U.S. Hence, our structural preference for currencies is euro first, pound second, dollar third. Which brings us finally to what medium-term investors should do after Super Thursday. If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. And use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Sinn Fein MPs are not eligible to vote because they refuse to pledge allegiance to the Queen. 2 Growth must be adjusted for different demographics. Our preference is to use real GDP per head based on working age (15-64) population. Fractal Trading Model* Euro/dollar is technically overbought, so traders can play a countertrend move. Target a 2% retracement. 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-9 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 Merkel is not revolutionizing but reaffirming Germany's Europhile policy; An earlier date for the Italian election would bring market jitters forward from Q1 2018; Yet a new German-style electoral law would decrease the risks of a populist win; The Tories will retain their majority in U.K. elections. Fiscal policy will ease regardless of the outcome; Close long Chinese equities versus Hong Kong/Taiwan; remain overweight Euro Area equities. Feature Possible early elections in Italy and a narrowing lead for Theresa May in the June 8 U.K. election has unsettled investors over the past week. The former threatens to rekindle the flames of the Euro Area conflagration and has weighed on Euro Area equities (Chart 1). The latter threatens Prime Minister May's mandate and political capital, suggesting that the U.K.-EU Brexit negotiations could be acrimonious later this year. This report deals with both issues. Yes, Italy is a major risk to the Euro Area, and despite general awareness of the election, it is not clear to us that investors realize the depth of the risk. As such, Euro Area equities may outperform developed market peers right until the election. As for the U.K. election, we think its impact on global risk assets is non-existent and its impact on U.K. assets is likely to be fleeting. The bigger threat to global markets remains China. In a March report, we suggested that Chinese policymakers may be testing the waters for broad-based financial and industrial sector reform akin to their late 1990s efforts.1 These reforms could be deflationary in cyclical terms and thus a risk for global growth. We argued that the timeline for these efforts would have to wait for the conclusion of the nineteenth National Party Congress this fall and thus Beijing's policy represented a potential problem for 2018.2 Chart 1Italy Weighs On European Risk Assets Chart 2China: Monetary Tightening Takes A Toll Then again, President Xi Jinping may flout the rule of thumb in Chinese politics that aggressive policy actions should wait until after the five-year party congresses. Monetary tightening - which could be the first salvo of broader financial-sector reform - has already had negative effects on the real economy (Chart 2). The economic surprise index has corrected, as have China's PMI and LEI. Further Chinese tightening would invariably hurt Chinese demand for imports (Chart 3), which would have negative knock-on effects for EM economies, whose growth momentum appears to have already rolled over (Chart 4). Investors should carefully monitor China over the summer. Any signaling from policymakers that they are willing to move away from the "Socialist Put" and towards genuine deleveraging (not to mention their promised free-market reforms) would have negative global implications. Our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, has pointed out that Europe's economic outperformance relative to the U.S. is highly leveraged to Chinese liquidity (Chart 5).3 As such, decisions made by policymakers in Beijing will likely be more important for European asset performance than who sits in Rome's Palazzo Chigi. Chart 3Tighter Credit Impulse##br## Will Drag Down Imports Chart 4A Chinese Import ##br##Drag Will Hurt EM Chart 5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity We are closing our long Chinese equities / short Taiwanese and Hong Kong equities trade for a gain of 3.45%. While policymakers are already backpedaling a bit, financial tightening inherently raises risks in an excessively leveraged economy. Europe Über Alles? Many clients are asking about German Chancellor Angela Merkel's recent comments on European unity. On the heels of the G7 summit, during which Merkel locked horns with U.S. President Donald Trump, Merkel delivered the most Europhile speech of her career: The era in which we could fully rely on others is over ... That's what I experienced over the past several days ... We Europeans truly have to take our fate into our own hands ... But we have to know that we Europeans must fight for our own future and destiny. To many in the media and financial industry the speech seemed like a massive departure from Merkel's cautious and reticent approach to European policymaking. We could not disagree more. European integration imperatives are intrinsically geopolitical, as we have argued since 2011.4 Members of the Euro Area are integrating not because of liberal idealism or misguided dogmatism on monetary union. Rather, they are engaged in a cold, calculated, and deeply realist political project to remain relevant in the twenty-first century. This net assessment has guided our analysis of various Euro Area crises. We supported our top-down theoretical view with bottom-up data showing that European voters were not revolting against integration. Integration may be elite-driven, but it has broad popular support. Support for the common currency has never dipped below 50% (Chart 6), despite a once-in-a-generation economic crisis, and most European states are pessimistic about their separate futures outside the EU (Chart 7). Chart 6Voters Approve Of The Euro Chart 7EU Exits: Not On Horizon German policymakers have operated within these geopolitical confines since the Euro Area sovereign debt crisis began in the waning days of 2009. At every turn of the crisis, whenever one or another German policymaker issued a "red line" regarding what "Berlin cannot accept," the correct view was to bet against that policymaker, i.e. against any Euroskeptic outcome. Since 2010, we have seen: Numerous direct bailouts of member states; A dove appointed to lead the ECB, with Berlin's blessing; Direct ECB purchases of government bonds; Deeper fiscal and banking integration of the Euro Area, albeit at a slow pace; Expansion - not contraction - of Euro Area membership; The reversal of fiscal austerity. We were able to forecast these turns because our constraint-based methodology gave us a high-conviction view that German policymakers would ultimately be forced down the integrationist, Europhile road. The German population did not revolt against these constraints. Germans are not Euroskeptic. We have no idea why many investors think they are: there is no evidence of it in data or history. German history is replete with failed efforts to unify (and lead) the European continent by hook or by crook. The country is cursed with just enough economic prowess to be threatening to its peers and yet not enough to dominate them by force. As such, it is a German national security imperative to ensure that it does not see the rest of Europe coalesce into an economic or military alliance against it. The EU and its institutions, which allow Germany to be prosperous without the threat of an enemy coalition, are therefore worth preserving, even at a steep cost. True, the costs of bailing out Greece, Ireland, Portugal, and Spain tested German enthusiasm for European integration. However, German support for the common currency never dipped below 60% amidst the sovereign debt crisis and has since rebounded to a record high of 81% (Chart 8). Only 20% of Germans are confident of a future outside the EU (Chart 9). Chart 8Rise Of The Europhile Germany Chart 9Germany: No Life After EU Death As such, Merkel's statement following the G7 summit is only surprising because it is explicit. Indeed, the reason Merkel made this statement now is not because she suddenly had a grand geopolitical realization, nor because Trump suddenly disabused her of a naïve belief in the benevolence of the United States. Merkel has understood Europe's imperatives for at least a decade. The real reason for her statement is domestic politics. Martin Schulz, Merkel's opponent in general elections to be held on September 24, has tapped into the rising Europhile sentiment among Germans. The Social Democratic Party (SPD) sprang back to life this year following Schulz's appointment as SPD chancellor-candidate. Despite a recent relapse for the SPD in the polls, Merkel wants to ensure that she is not vulnerable on her left flank to the more Europhile Social Democrats. In the face of this renewed threat from the SPD, the venue of Merkel's speech was highly symbolic: a summit of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), held in a beer hall no less! Bavaria is the most conservative and Euroskeptic part of Germany. Over the past two years, the CSU has flirted with abandoning its post-war electoral alliance with the CDU due to Berlin's various Europhile turns. This development threatened to undermine Merkel and her base of power from within. Merkel's speech, to the most Euroskeptic part of Germany, was designed to prepare her conservative base for a further deepening of European integration. It was not a policy shift but rather a statement that brought her rhetoric more in line with her policy actions. It was also a reminder to her core allies that they must continue on the current policy path unless they would rather have Schulz's SPD force them into even deeper European integration, and faster. What does this mean going forward? We think that the dirty word of European politics - "Eurobonds" - will come into play again. As if on cue, the European Commission has published a report that proposes bundling the debt of Euro Area sovereigns.5 The proposal is not exactly calling for Eurobonds, but rather for securitizing existing bonds into new instruments. As usual, a German finance ministry spokesperson opposed the plan. However, the path of least resistance will be towards more integration that may include such securitization. In fact, Eurobonds already exist. Europe's fiscal backstop mechanisms - formerly the European Financial Stability Facility (EFSF) and now the European Stability Mechanism (ESM) - have both issued bonds to finance sovereign bailout efforts. So has the European Investment Bank (EIB). Their bonds trade largely in line with French sovereign debt, with a 37 basis point premium over German 10-year Bunds (Chart 10). Most importantly, the European Commission - the executive arm of the EU - already has authority to issue bonds and even tap member states for funds in case it needs to fill a gap. As the European Commission cites in its pitch-book to bond investors (yes, you read that correctly), "should the funds available from the EU budget be insufficient, the Commission may directly draw on the Member States, without any extra decision making being required."6 Currently, EU treaties forbid bond issuance that would directly finance the budget of a member state. However, Article 143 lays down the possibility of granting mutual assistance to an EU country facing a balance-of-payments crisis, which the EU Commission handles via its €50 billion balance-of-payments assistance program. In the future, the Commission could issue bonds to finance joint, EU-wide projects for areas like defense or infrastructure. It does not appear that such a decision would require a change to EU treaties. Over the long term, the integration imperative will remain strong in Europe. Ironically, Donald Trump is probably the best thing that has happened to European unity, at least since President Vladimir Putin. However, we think media commentators may be overstating President Trump's impact. The U.S. was already growing aloof toward Europe under President Obama, who overtly tilted his foreign policy towards Asia, and President Bush, whose administration clashed with "old Europe" and merely flirted with "new Europe." With the prospect of the U.S. withdrawing its security blanket, Europeans are being forced to integrate. Otherwise they would have to deal with the full range of global crises - from debt to terrorism to migration to war - as separate, and weak, individual states. And the U.S. is unlikely to return to its post-World War II level of concern regarding European affairs anytime soon. We doubt that even a recession would greatly impede the integrationist impulse on the continent. The Great Financial Crisis was a once-in-a-generation economic crisis and yet it has deepened, not decreased, support for integration. That said, risks remain. While the median voter in Europe appears to support the elite-driven integrationist effort, the median voter in Italy is on the fence. Bottom Line: Merkel's Europhile speech in Bavaria was meant to reinforce the ongoing integrationist path to her domestic audience in an election year. We suspect that Germany under Merkel, along with France under recently elected President Emmanuel Macron, will continue down the same path. At some point in the not-so-distant future, this may include the issuance of Eurobonds for specific projects. Our long-held geopolitical view supports overweighting Euro Area risk assets, given economic momentum and valuations. However, near-term political risks in Italy are substantial and pose the main risk to our strategic view. Italy's Divine Comedy - Coming Soon To A Theater Near You? Early Italian elections - in September 2017, instead of February-May 2018 - have become a real possibility. Matteo Renzi, leader of the ruling Democratic Party (PD) and former prime minister, recently signaled that he would be willing to compromise on a new electoral law, and that it could pass as early as July, given a tentative agreement with the Forza Italia party of former prime minister Silvio Berlusconi. This would satisfy the condition of President Sergio Mattarella that a new electoral law be passed before elections can proceed. What does this development mean for markets? Italian political elites share the same integrationist goals of their European peers. There is no logic in Italian independence from the EU. Rome's ability to patrol its coastline for smugglers bringing in migrants would not improve with independence, nor would its ability to negotiate a low price for Russian natural gas. Italy is, as much as any European country, in terminal decline as a geopolitical power. Membership in the EU is therefore a natural, and realist, response to its weakness. In addition, exiting the monetary union would be fraught with risks that would overwhelm any benefits that Italian exports may gain from devaluation. It is highly unlikely that Germany, France, Spain, and the Netherlands would allow Italy - the Euro Area's third largest economy - to set a precedent of using massive currency devaluation while maintaining access to the Common Market. Rome would in fact break its Maastricht Treaty obligations. These stipulate that every member state, save for Denmark and the U.K., must become a member of the EMU. It would likely be evicted from both the EU and the Common Market. Furthermore, as we discussed in our September net assessment of Italy, the country's 19th nineteenth century unification has never made much sense.7 We would go so far as to argue that Euro Area amalgamation makes more sense than the unification of Italy. Northern Italy remains as much part of "core Europe" as London, the Rhineland, or the Netherlands, whereas the south - the Mezzogiorno - might as well be in the Balkans. We do not see how Rome would afford the Mezzogiorno on its own without access to both the EU's markets and ECB-induced low financing costs. All that said, the median Italian voter is not buying the Euro Area at the moment. Unlike their European peers, Italians seem to be flirting with overt Euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 50% (Chart 11). Similarly, a plurality of Italians appears to be confident in the country's future outside the EU (Chart 12). Chart 11Italy A Clear Outlier On The Euro Chart 12Italians Willing To Go Solo? Of course, only about a third of Italians identify themselves as only "Italians," largely in line with the Euro Area average and nowhere near the trend in Britain, where the share of the public that feels exclusively British has generally ranged from half to two-thirds (Chart 13). Nevertheless, the Euroskeptic trend in Italy is real and jeopardizes European integration. Our high-conviction view that European politics would be a "red herring" in 2017 was originally based on data that showed that voters in the Netherlands, France, and Germany increasingly supported European integration. This allowed us to dismiss polls that suggested that Euroskeptic politicians - such as Geert Wilders or Marine Le Pen - would do well in this year's elections. Even if they did perform well, the median voter's stance on European integration would force such policymakers to modify their Euroskepticism. This process has already happened in Spain (Podemos), Finland (The Finns, formerly known as the True Finns), and Greece (SYRIZA). In Italy, however, the median voter's Euroskepticism has not abated. As such, parties such as the Five Star Movement (M5S) and Lega Norde (LN) have no political incentive to modify their Euroskepticism. In fact, LN has done the opposite, evolving from a liberal and pro-EU regional sovereignty movement into a far-right, anti-immigrant, Euroskeptic, and nationalist Italian party -- a full brand overhaul. The timing of the upcoming election is difficult to forecast. Nonetheless, Renzi's compromise on changing electoral rules has now increased the probability that the election be held in Q4 2017, instead of Q1 2018. Renzi reportedly favors the same date as the German election, September 24. To accomplish this timetable, the new electoral law would have to be rushed through Italy's bicameral Parliament. The Chamber of Deputies - the lower house - is expected to vote on the compromise law in the first week of June, with the Senate passing the law by July 7. Given that the top four parties all seem to agree with adopting a German-style electoral system - proportional representation, with parties required to gain at least 5% of the vote to gain any seats - this ambitious timeline is possible. However, there are still some minor outstanding issues, which could drag out the process until the fall. In addition, local elections scheduled for June 11 (with a second-round run-off on June 25) could change the calculus of the ruling PD. If Renzi's party underperforms, he may back away from early elections, although the message would be that a strong populist performance in early 2018 is more likely. Polls have not budged much for the past 18 months, although Renzi's PD lost support around the time of its failed December 2016 constitutional referendum (Chart 14). The market may find solace in the fact that the revised electoral law would grant no "majority-bonus" to the winner, virtually ensuring that the Euroskeptic M5S cannot govern on its own. Chart 13Majority Of Italians Are Also Europeans Chart 14Ruling Party And Populist M5S Neck-In-Neck The risk to the market, however, is that M5S outperforms and then creates a limited coalition with right-wing Euroskeptics. Such a coalition could have the singular goal of calling a "non-binding, consultative" referendum on Italy's Euro Area membership. The official M5S line is that it would call such a referendum "if fiscal policies of the Euro Area did not change." Either way, the Italian constitution forbids referendums on international treaties, but a consultative referendum would give impetus to Euroskeptic parties to start negotiating a Euro Area exit for the country. There are two reasons why such an outcome is possible, if not our base scenario. First, a German-style 5% threshold will eliminate the votes cast for a number of minor parties from the overall calculation. These currently combine to make up about 18% of the total vote. This means that the parties that meet the 5% minimum will gain a larger share of seats in the parliament than they gained of the overall popular vote (82% of the vote will hold 100% of the seats), as is the case in Germany. There is a chance that both the PD and M5S get a considerable seat boost in the final tally that puts them close an overall majority. Second, much will hinge on whether the right wing - and Euroskeptic - Fratelli d'Italia (FdI) enter parliament. They are currently polling at about 5% of the vote. If they gain seats, it would significantly increase the percentage of total seats held by Euroskeptic parties. There is no evidence at the moment that M5S, which is on the left of the policy spectrum, would contemplate such an electoral alliance with LN and FdI. The party remains opposed to any coalitions and we suspect that it would not break its pledge to pursue the highly risky strategy of calling a referendum on the Euro Area. The M5S stands for a lot of different things: anti-corruption, anti-establishment, youth empowerment, etc. Euroskepticism is one of its pillars, not a singular objective. In fact, party leader Beppe Grillo recently attempted to abandon the Euroskeptic alliance with UKIP at the European Parliament to join the ultra-liberal, and Europhile, Alliance of Liberals and Democrats for Europe. Various factions vying for control of the movement oscillate between overt Euroskepticism, aloofness toward Europe, and open support for European integration. In addition, Italian voters may adjust ahead of the election by switching their support away from the various minor parties currently polling below 5% and toward the four major parties. This will likely benefit the ruling PD more than any other party. Out of the four parties highly unlikely to cross the 5% threshold - Campo Progressista (CP), Movimento Democratica e Progressista (MDP), Alternativa Popolare (MP), and Sinistra Italiana (SI) - three are centrist or aligned with the PD. One (Sinistra Italiana) would likely see its voters split between the PD and M5S (Chart 15). Such vote migration would clearly benefit the center-left PD, which Renzi is likely counting on in accepting the German-style proportional electoral system.8 Chart 15Most Minor Party Votes ##br##Would Help Ruling Democrats Bottom Line: Investors trying to make sense of the Italian election will find relief in the new electoral law. A purely German-style system - given the current level of factionalism in Italian politics - is unlikely to produce a populist government in Italy. In fact, the center-left PD could see a boost in support as voters switch away from minor parties. The tentative compromise on the electoral law has both increased risks by making an earlier election more likely and decreased risks by reducing the probability of an anti-market result. That said, there is still a possibility that M5S crosses the ideological aisle to form an alliance with right-wing Euroskeptics to try to take Italy out of the Euro Area. We doubt that they will do so. Nonetheless, it will be appropriate to hedge such a risk in currency markets closer to the date of the election, once the date is known. We therefore closed our long EUR/USD recommendation last week for a gain of 3.48%. Whatever the outcome of the election, Italian political risks will remain the main threat to European integration (and assets) going forward. We therefore expect the ECB to keep one eye on Italy, forcing it to be less hawkish than it otherwise would be. We will explore Italian politics and economy further in an upcoming report with our colleagues at BCA's Foreign Exchange Strategy. U.K.: The Election Is About G The latest polling averages show that Prime Minister Theresa May's Conservative Party maintains a 5% lead over Jeremy Corbyn's Labour Party, despite Labour's remarkable rally since early elections were called on April 18 (Chart 16). One projection of actual parliamentary seats that takes into account the crucial factor of voter turnout suggest that the Tories could add from 15 to 34 seats to their 2015 take of 330 seats - and this roughly matches our back-of-the-envelope calculation that the Tories could pick up 11 seats on account of the Brexit referendum (Table 1).9 Chart 16Labour Revives On Snap Election Table 1Referendum Results Offer Some Simple Gains For Tories There have been only two other cases in recent memory in which Britain's incumbent party led by double digits two months ahead of an election: 1983 and 2001. In the first case, Margaret Thatcher followed up the hugely successful Falklands campaign by expanding her popular support in the final two weeks to win a huge 144-seat majority. In the second case, Tony Blair lost some of his lead but still won the election handily.10 There has not been a case in recent memory where a double-digit lead dropped into single digits as quickly as it did this past month. Moreover, looking at the latest individual polls, it is too soon to say that Labour's rally has ended. Indeed, YouGov's model even shows the Conservatives losing their majority.11 Snap elections are always a gamble, as we have stressed throughout this campaign.12 There is no question that Labour has the momentum and May is feeling the heat. Yet the Tories have a fairly solid foundation of support at the moment. First, they are still polling above 40% support, almost 10% higher than before the referendum, reflecting the rally-around-the-flag effect after voters' surprising decision to leave the EU. They even poll above 40% among working-class voters, the original base of Labour, and the country's aging demographic profile also heavily favors them. (Youth turnout would have to surprise upward to upset the Tories.) Second, the Tory strategy of gobbling up supporters of the U.K. Independence Party (UKIP) has succeeded (Chart 17). UKIP has no raison d'être after achieving its foundational goal of Brexit. The Conservative Party's decision to hold a referendum on the EU was, in fact, driven by this rivalry from the right flank. UKIP posed the chief threat to the Tories through its ability to dilute their vote share in Britain's first-past-the-post electoral system. Now, almost all conservative voters will vote for the Conservative Party, while Labour must still compete with the Liberal Democrats, Greens, Scottish National Party, and Welsh Plaid Cymru in various constituencies (Chart 18). Chart 17Tories Keep Devouring UKIP Chart 18Labour Has Rivals, Tories Do Not Third, while May's popularity is merely converging with her party's still-buoyant level, Corbyn is less popular than both May and his own party (Chart 19). Corbyn still has a net negative favorability and is seen as less "decisive" and less "in touch" with voters than May. Fourth, voters still see Brexit as the most important issue of the election (Chart 20) and May as the best candidate to manage the tricky exit negotiations ahead. Because Brexit is the driver, the benefit of the doubt goes to the Tories. The 2015 elections, the EU referendum, the polls since the referendum, and the parliamentary votes (driven by popular pressure) enshrining the referendum result all suggest a great deal of public momentum on this key issue. The only truly historic development that could have broken this momentum, given that the economy is holding up, is the Tory decision to seek a "hard Brexit," i.e. exit from the EU's Common Market. Yet opinion polls show that Brexit still has the support of a majority of likely voters; moreover, 55% of voters would rather have "no exit deal" than "a bad exit deal."13 If voters still see this as the defining issue, then the Tories still have a key advantage. On the other hand, perceptions of Jeremy Corbyn and Labour have improved rapidly and May's simultaneous popularity slump is especially important in this election. She is a "takeover prime minister" (having initially gained the office when Cameron resigned rather than leading her party into an election as the presumed prime minister) and thus highly vulnerable. This election is largely about her need for a "personal mandate."14 Her political missteps (both real and perceived) are very much at issue in this particular election. Chart 19May Lifts Tories, Corbyn Drags Labour If polls continue to narrow, the election could produce a "hung parliament," in which no single party holds the 326 seats necessary for a majority in the House of Commons. What should investors expect in that scenario? First, May would have the chance to rule a minority government or form a coalition. A minority government would be weak, vulnerable to collapse under pressure, and would have a harder time controlling the Brexit negotiations. As for a coalition, there is very little chance that the other major parties would cooperate with her - the Liberal Democrats would not reprise their role as coalition partner from 2010-15. But there is a slim chance that the Democratic Unionist Party (DUP) of Northern Ireland could unite with the Tories to obtain a majority. The DUP has not exercised real power in a century, literally, and several of its members do not normally even take their seats in Westminster. However, the party is Euroskeptic and could provide just enough support to accomplish the single goal of a Tory-led Brexit. Suffice it to say that this outcome is not impossible - the Tories have been courting the DUP for months and the existence of a historic "common cause" changes the usual parliamentary dynamic. Still, this arrangement would be highly unusual, causing a massive uproar, and would lead to all kinds of uncertainties about parliament's ability to pass a final Brexit deal in 2019. Second, assuming May fails, the Labour Party would have to rule in the minority or form a coalition (if informal) with the Scottish National Party, LibDems, Plaid Cymru, Greens, and others. Here are the most likely outcomes of such an arrangement, in broad brush strokes: Brexit will in all likelihood proceed, given that all parties have professed respect for the referendum outcome. Since the new government would likely not seek to curtail immigration as strictly, it could seek to retain membership in the Common Market. However, a la carte membership in the Common Market remains the greatest difficulty with the EU member states, and therefore it is possible that even Labour would have to accept the logic of exiting the Common Market. In fact, we could see Labour's insistence on access to the Common Market producing more acrimony with the EU than the Tory clean-break strategy. Nevertheless, the odds of a "Brexit cliff" in which the U.K. exits without a trade deal would fall from their already low level, given Labour's unwillingness to let that happen. Despite moving ahead with Brexit, a Labour-led government would increase the relatively low probability of an eventual reversal of the decision, given that it would be more inclined to accept or encourage such an outcome in the face of a bad exit deal, a recession, or other challenges that cause public opinion to shift. The Scottish National Party would probably sideline its demands for a second Scottish independence referendum - especially given that polls supporting a second referendum have floundered for the time being - though not permanently.15 Fiscal spending would increase as a result of Labour's and the SNP's campaign promises and greater focus on domestic social issues. Even if May avoids squandering her party's majority (our baseline case), there are several important takeaways from her drop in the polls: Chart 21Dementia Tax' Gaffe Added To Tory Woes The median voter wants government support: The Labour Party's rally began as soon as elections were called, with left-leaning voters switching away from the LibDems once they saw a chance to challenge the ruling party. But the Tories took a hit from May's unprecedented (and publicly awkward) reversal on a party manifesto pledge only days after publishing it (Chart 21). The pledge, now infamous as the "dementia tax," was an attempt at fiscal tightening by which the government would include the value of an elderly person's home in the assessment of their financial means when it came to government support for social care. By contrast, Labour has rallied on the back of a party manifesto that promises fiscal expansion in various categories, including £7.7 billion additional funds for health care, social care, and nursing. More broadly, National Health Service funding, rent caps, and a higher "living wage" are the top four campaign pledges that gain above 60% popular support. As we elucidated last year, the two economies that most enthusiastically embraced a laissez-faire model - the U.S. and the U.K. - are now experiencing the most effective swing to the left.16 The U.K. campaign confirms that, with the Tories minimizing cuts and Labour offering greater spending. Brexit means Brexit: 69% of the public claims that government should follow the referendum outcome, and 52% favor Theresa May's proposed Brexit strategy. The opposition parties are not openly opposing the referendum outcome, as mentioned. Moreover, Labour's pledge to prevent the U.K. leaving the bloc without a trade deal is one of the least popular campaign pledges (only 31% approve), while the Liberal Democrats' pledge to hold a second nationwide referendum on the outcome of the exit talks is also unpopular (34% approve) (Chart 22). Labour is recovering support by focusing on its bread-and-butter, left-wing, social platform. Terrorism is not driving voters: The tragic terrorist attacks at parliament, Manchester, and London Bridge have hardly given May and the Tories any additional support despite being the party viewed as stronger on security. Amid a bull market in terrorism, British voters, like European peers, are becoming somewhat inured to periodic attacks against "soft" targets.17 Health is a bigger concern than immigration: A large majority of Britons think immigration has been too high in recent years, but only about 25% think it is a major issue facing the country, compared with 43% who cite health care as a major issue (see Chart 20 above). These are not completely independent issues because many people believe that immigrants are putting pressure on scarce health care resources. Immigration is closely tied to Brexit and will remain a burning issue if the government does not convince voters that it is more vigilant. But the Labour Party's greater support on health care (as well as education and other social issues) is a growing liability to the Tories as Brexit becomes more settled. If Brexit was a revolt against the elites, it is not necessarily the only manifestation of that revolt. The elitist Tories should be careful that they do not rest on their laurels having been on the right side of that particular issue. The key takeaway is that, aside from Brexit, fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then.18 That is also why the ruling party has already eased fiscal policy. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline to beyond 2022 (Chart 23). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 24). The Tories are also claiming that they will reboot the country's industrial strategy to improve productivity, which will become all the more imperative if they even partially follow through on their pledge to cut immigration numbers from the current annual ~250,000 to under 100,000, which will necessarily reduce labor force growth and thus also potential GDP growth.19 The National Productivity Investment Fund will need a projected £23 billion just to get on its feet. Given that Labour is proposing even more ambitious spending increases (£49 billion additional spending through 2022), the direction of U.K. politics - away from austerity - is clear regardless of the election outcome. Finally, our colleagues at BCA's Global Fixed Income Strategy expect the Bank of England to maintain loose monetary policy for the foreseeable future, being unable to turn more hawkish against inflation in the context of continued risks and uncertainties related to Brexit.20 Thus monetary and fiscal conditions are both accommodative for the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports,21 the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, could weigh on the pound regardless of the election outcome. As such, we closed our short USD/GBP last week for a gain of 3.34%. Bottom Line: We do not expect a hung parliament; most signs suggest that the Tories will retain at least a weak majority. However, a hung parliament that produces a Labour-SNP alliance would not likely reverse Brexit (though it would make a reversal more conceivable). Such an alliance could eventually result in an exit deal that is both less politically logical than the Tory deal (because London would pay to stay in the Common Market yet have less say in how it is managed) and more favorable to the British economy in the long run (because retaining the benefits of Common Market access). But this is not a foregone conclusion. We maintain our view that Brexit itself has largely ceased to have concrete market-relevant impacts other than a decline in Britain's long-term potential GDP growth. There are two reasons for this. First, May has ruled out membership in the Common Market and thus has removed a potential source of acrimony with Brussels over any "special treatment." Second, the EU does not want to precipitate a crisis in the U.K. that could reverberate back onto the continental economy. Investment Implications We remain strategically overweight European equities relative to their U.S. peers, a trade that has returned 7.39% thus far. We would remind clients that we closed our long GBP/USD and long EUR/USD tactical trades last week for 3.34% and 3.48% gains, respectively. We are also booking a 3.45% profit on our "One China Policy" strategic trade (long Chinese equities as against their Taiwanese and Hong Kong peers). We still think policymakers will do everything they can to keep China's economic growth stable ahead of the party congress this fall, but, as we discussed in our May 24 missive,22 the decision to tighten financial regulation is risky and threatens to cause unintended consequences. 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, “China Down, India Up?” dated March 15, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, “ECB: All About China?” dated April 7, 2017, available at fes.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, “Europe’s Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011; and “Europe: The Euro And (Geo)politics,” dated February 11, 2015, available at gps.bcaresearch.com. 5 Please see European Commission, “Reflection paper on the deepening of the economic and monetary union,” May 31, 2017, available at ec.europa.eu. 6 Please see European Commission, “EU Investor Presentation,” April 7, 2017, available at ec.europa.eu. 7 Please see BCA Geopolitical Strategy Special Report, “Europe’s Divine Comedy: Italian Inferno,” dated September 14, 2016, available at gps.bcaresearch.com. 8 The only minor party that is Euroskeptic, FdI, is just close enough to the 5% threshold that its voters are unlikely to abandon it. They will not likely give the Euroskeptic Lega Norde and M5S much of a boost. 9 Please see Lord Ashcroft Polls, “2017 Seat Estimates: Overall,” May 2017, available at lordashcroftpolls.com. 10 In the 1997 election, Tony Blair and Labour led by double digits, but they were in the opposition. Their lead in the polls shrank slightly before Blair won a 178-seat majority, even larger than Thatcher’s 144 seats in 1983 and Clement Attlee’s 147 seats in 1945. 11 Please see YouGov, “2017 UK General Election Model,” accessed June 6, 2017, available at yougov.co.uk. 12 Please see BCA Geopolitical Strategy Weekly Report, “Buy In May And Enjoy Your Day!” dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see Anthony Wells, “Attitudes to Brexit: Everything We Know So Far,” March 29, 2017, available at yougov.co.uk. 14 Please see footnote 12 above. 15 Please see The Bank Credit Analyst and Geopolitical Strategy Special Report, “Will Scotland Scotch Brexit?” dated March 30, 2017, available at bca.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, “Brexit Update: Does Brexit Really Mean Brexit?” dated July 15, 2016, and “Brexit Update: Red Dawn Over Britain” in Geopolitical Strategy Monthly Report, “King Dollar: The Agent Of Righteous Redistribution,” dated October 12, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, “With Or Without You: The U.K. And The EU,” dated March 17, 2016, available at gps.bcaresearch.com. 20 Please see BCA Global Fixed Income Strategy Weekly Report, “Adventures In Fence-Sitting,” dated May 16, 2017, available at gfis.bcaresearch.com. 21 Please see “Brexit: A Brave New World” in BCA Geopolitical Strategy Weekly Report, “The ‘What Can You Do For Me’ World?” dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, “Northeast Asia: Moonshine, Militarism, And Markets,” dated May 24, 2017, available at gps.bcaresearch.com.
Highlights Through the 18 years of the euro, growth in 'core' Germany and France and 'periphery' Spain has equalled that in the U.S., U.K. and Canada. But Italy has severely underperformed since 2008. Italy's economic underperformance is due to the uncured malaise in its banks. Fixing Italian banks will fix Italy and reduce euro breakup risk. Euro area equities and periphery bonds do offer long-term relative value on the premise that euro breakup risk does ultimately fade. But for those who can time their entry, await the outcome of the Italian election. Feature The euro recently had its 18th birthday.1 Through the formative, testing and often tempestuous first 18 years of its life, how have the euro area's main economies performed - and how do these performances compare with the developed world's other major economies? The answers might come as a surprise (Chart of the Week). Chart of the WeekItaly Has Severely Underperformed Since 2008. Why? To allow for the different demographics, we must look at growth in real GDP per head.2 On this metric, the gold medal goes to Japan, with 34% growth. During the euro's lifetime, Japan's real GDP has grown by 18%, but its working age population has shrunk by 12%, resulting in the developed world's best real growth per head.3 The silver medal winner is probably not surprising: Germany, with 28% growth. But the bronze medal winner might surprise you. It is a euro 'periphery' country: Spain, with 26% growth - a medal shared with the U.K. Then come Canada, 24%; the U.S., 22%; and France, 19%. So through the 18 years of the euro, Germany, France and Spain have performed more or less in line with the U.S., U.K. and Canada. Making it very difficult to argue that being in the single currency has penalized the growth of either 'core' Germany and France or 'periphery' Spain. Italy Isn't Partying... But Don't Blame The Euro Unfortunately, there's a problem - Italy. Through the 18 years of the euro, Italy's real GDP per head has grown by just 5%, substantially below any other G10 or G20 economy. If the euro is to blame for the significant underperformance of its third largest economy with 60 million people, then the single currency's long-term viability has to be in serious doubt. However, two pieces of evidence suggest that the euro per se is not to blame for Italy's painful underperformance. First, observe that through 1999-2007, Italian real GDP per head kept up with many of its G10 peers. Even without a substantial tailwind from a credit-fuelled housing boom - which other economies had - Italian real growth per head performed in line with France, the U.S. and Canada (Chart I-2). Chart I-2Through 1999-2007, Italy Grew In Line With France, The U.S. And Canada Second, in the post-crisis years, there was little to distinguish the economic performance of Italy from Spain until 2013 (Chart I-3). Only after 2013 has a huge gap opened up. While Italy has struggled to grow, Spain has taken off, expanding by more than 12%. This recent strong recovery in Spain makes it hard to attribute Italy's underperformance to membership of the single currency (per se). Chart I-3Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Fix Italian Banks To Fix Italy We believe that Italy's economic underperformance is down to the as yet uncured malaise in its banks. Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the housing-related credit booms in the U.S., U.K., Spain and Ireland did eventually cause housing busts and full-blown financial crises - requiring urgent government-led and central bank-led bailouts. Crucially, the acute financial crises in the U.S., U.K., Spain and Ireland forced their policymakers to recapitalize the banks, and thereby allowed the bank credit flow channel to function again. For example, Spain's turning point came in 2013, when bank equity capital as a multiple of non-performing loans (NPLs) started to recover (Chart I-4), allowing Spanish banks to operate more normally. Chart I-4Spanish Banks' Solvency Recovered In 2013 But Spanish banks' health did not recover because NPLs declined; indeed, if anything, NPLs continued to increase (Chart I-5). Spanish banks' health improved because of a large injection of bailout equity capital (Chart I-6). By contrast, Italian banks have not yet received the injection of equity capital that is desperately needed to fix Italy's bank credit flow channel. Chart I-5NPLs Continued To Rise Everywhere Chart I-6French And Spanish Banks Have Raised Equity. Italian Banks Have Not. To lift Italian banks' equity capital to NPL multiple to the lowest level that Spanish banks reached before recovery would require €80-100 billion of fresh bank equity capital. Which equates to 5-6% of Italian GDP. The good news is that this is an affordable price if it kick starts long-term growth. The bad news is that Italy's avoidance of outright financial crisis (thus far) has now tied its hands. The EU Bank Recovery and Resolution Directive (BRRD), which came into full force on January 1 2016, has blocked the state bailout escape route that Spain and Ireland used. Granted, in a crisis, the BRRD would allow Italian government state intervention to aid a troubled bank. But the overarching aim would be to protect banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors. "Other parts may be allowed to fail in the normal way... after shares in full... then evenly on holders of subordinated bonds and then evenly on senior bondholders." Without a crisis, the process to recapitalise Italian banks and expunge NPLs would be largely up to the private sector and markets. But a long chain of events from the repossession of assets under bankruptcy law, to valuation, to full divestment from the banks' balance sheets could take years. Our concern is that such a protracted nursing to health will keep Italy's bank credit channel dysfunctional, thereby leaving economic growth in a 60 million people economy sub-par for an extended period. Only when the Italian banks are adequately recapitalized, will the danger of a financial or political tail-event - and a euro breakup - be fully exorcised. Unfortunately, the danger may first have to rise before policymakers allow the necessary action. But ultimately they will. Some Investment Thoughts If euro breakup risk does ultimately fade, then euro area equities will receive a tailwind relative to other markets. This is because relative to these other markets, euro area equity prices are discounted to generate a 1.5% excess annual return through the next 10 years - as a risk premium for euro breakup.4 So if this risk premium suddenly and fully vanished, relative prices would have to rise by 15%. Likewise, euro area periphery bond yields can compress further - as the yield premium effectively equals the perceived annual probability of euro breakup multiplied by the expected currency redenomination loss after the breakup. So euro area equities and periphery bonds do offer long-term relative value on the premise that the policy steps needed to boost Italian growth are affordable and relatively minor - and that euro breakup risk does ultimately fade. However, for those who can time their entry, await the outcome of the Italian election due to take place within the next year. Breakup risk may flare up again before it does ultimately fade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The euro was born on January 1st 1999. 2 Zeal GDP divided by working age (15-64) population 3 1.18/(1-0.12)=1.34 4 Please see the European Investment Strategy Weekly Report "Markets Suspended In Disbelief" published on April 13 2007 and available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 * 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. 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 Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Chart 4...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. 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, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar
Highlights The equity risk premium (ERP) is distorted: too low. The Eurostoxx600 uptrend is reaching a technical limit according to its 130-day (6-month) fractal dimension. The U.S.-Euro area bond yield spread is distorted: too high. The Spain-France bond yield spread is distorted: too high. The Italy-Germany bond yield spread is not distorted. Feature Central banks' massive interventions in markets have left many investors wondering: has the market's price discovery mechanism become dysfunctional - and if so, where most severely? It is a good question because clearly, the prices that are most distorted are also the ones most likely to dislocate, and generate lucrative opportunities. This week's report assesses the distortion in three important relative pricings: the Italy-Germany sovereign yield spread; the U.S.-euro area sovereign yield spread; and the prospective excess return from equities over bonds, otherwise known as the equity risk premium. The Italy-Germany Bond Yield Spread Is Not Distorted We often hear the claim that the ECB's bond purchase program has compressed periphery bond yields relative to core yields. But we find no evidence for such a distortion. For example, relative to the ECB's capital key1 and other guidelines for bond purchase volumes, there is a larger ongoing supply of Italian BTPs than German bunds.2 So from a technical perspective, the ECB's interventions should have depressed German bund yields more than Italian BTP yields, thereby expanding the spread. Chart Of The WeekLow Volatility: We've Been Here Before... And It Didn't Last In fact, the technical distortion seems quite small because the Italy-Germany yield spread can be fully justified by its two underlying fundamentals: relative competitiveness (Chart I-2) and euro breakup probability (Chart I-3). Chart I-2Euro Area Yield Spreads Depend On Relative Competitiveness ... Chart I-3... And The Probability Of Euro Break-Up The premium on Italian BTP yields exists as a compensation for the expected redenomination loss in the tail-event of euro breakup. Assuming this currency depreciation would neutralize Italy's current 25% under-competitiveness versus Germany, we can infer that the 125 bps yield premium on 5-year BTPs is pricing a 5% annual probability of euro breakup (because 125 bps = 25% loss times 5% probability). The probability should account for an Italian election that is due within the next year, and Italian public support for the euro hovering at an unconvincing majority of around 55%. In this context, the probability should be somewhat elevated, though not alarming. So a 5% annual probability of euro breakup through the next five years seems reasonable within its post-crisis 2%-20% range. On this basis, the Italian-Germany yield spread is not distorted (Chart I-4). Instead, the real anomaly is the Spain-France (5-year) yield spread which stands at 50 bps (Chart I-5). There is now no difference in competitiveness between Spain and France, so there should be no redenomination premium on Spanish Bonos over French OATs, irrespective of the probability of euro break up. Stay structurally overweight Spanish Bonos versus French OATs. Chart I-4The Italy-Germany Yield Spread At 150 Bps Is Fair Chart I-5The Spain-France Yield Spread At 50 Bps Is Too High The U.S.-Euro Area Bond Yield Spread Is Distorted: Too High If bond price discovery were based solely on economic fundamentals, the U.S.-euro area yield spread would not be at a multi-decade extreme today. Such an extreme spread exists because the difference between Fed and ECB policy is much more polarized than is justified by the economic fundamentals. In this sense, the relative pricing is distorted. Consider the hard data. The percentages of the working age population in employment are at the same respective pre-crisis highs in both economies; the difference in wage inflation is closing; and the gap between core inflation in the U.S. and euro area has narrowed very sharply to just 0.6%. Indeed, excluding the cost of shelter - which is not represented in the euro area CPI - core inflation in the U.S. is now lower than in the euro area. Agreed, Fed policy should be tighter than ECB policy. But the expected difference should not be at a multi-decade extreme. Given the self-proclaimed 'data-dependency' of both the Fed and the ECB, the polarization of monetary policy expectations (Chart I-6) has to converge to the rapidly narrowing gap in the hard economic data, one way or another (Chart I-7). Chart I-6The U.S.-Euro Area Yield ##br##Spread Is Too High ... Chart I-7... And Will Gravitate To The Narrowing ##br##Gap In The Economic Data I conclude that: the U.S.-euro area (and U.S.-Germany) yield spread can close much further; euro/dollar can rise structurally; and the market neutral equity pair-trade long euro area Financials/short U.S. Financials can continue to outperform. The caveat is that these positions are just one big correlated trade (Chart I-8 and Chart I-9). Chart I-8Expected Monetary Policy Difference ##br##Is Driving The U.S.-Germany Yield Spread ... Chart I-9... And Therefore The Relative ##br##Performance Of Financials The Equity Risk Premium Is Distorted: Too Low Equity market behaviour is starkly asymmetric; market ascents tend to be gentle and drawn out, while descents tend to be violent and abrupt. By contrast, bond market behaviour is more symmetric; both upward and downward moves can be gentle or violent. The upshot is that when the equity market is ascending, its observed volatility declines. And the longer and more established the ascent becomes, the lower the observed volatility goes, both in absolute terms and relative to bonds. Crucially, this is just an observation of the inherent behaviour of equities: a low observed volatility simply tells us that equity ascents are gentle and drawn out (Chart I-10); it does not tell us that equity risk has diminished. Chart I-10Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. ##br##It Does Not Tell Us That Equity Risk Has Diminished! Unfortunately, the decline in the observed volatility may create the illusion that equity risk has diminished. In response, investors might demand a smaller (or no) equity risk premium (ERP) - the excess prospective long-term return over bonds - because they have falsely concluded that the risk of a large intermediate loss is vanishing. In turn, the shrinking ERP and lower required return justifies an even higher price today, allowing the market to continue its gentle ascent. So observed volatility falls even further, and the process feeds on itself in a self-reinforcing spiral. Readers might recognise this as the setup of the Minsky hypothesis in which the illusion of systemic stability breeds systemic instability and an eventual tipping point - a so-called 'Minsky Moment'. The Minsky hypothesis is an explanation for the boom bust cycle in the economy. It proposes that a credit boom initially generates strong and steady growth with low observed volatility. But the associated hubris - "no more boom and bust" - eventually encourages reckless lending and thereby sows the seeds of its destruction. When the misallocated loans cannot be repaid, the inevitable nemesis arrives. Likewise, in the case of the equity market, today's low observed volatility is absolutely not a reason for hubris. Yet as demonstrated in Markets Suspended In Disbelief,3 the low observed volatility has seduced investors into accepting a wafer-thin ERP. Today's low observed volatility is at the lower end of a range that has existed for at least 50 years (Chart of the Week). We have been here many times before. In each case, the low observed volatility did not last. And when it rose, so too did the ERP. As supporting evidence, observe that the 130-day (6-month) fractal dimension of the Eurostoxx600 is suggesting that the current uptrend is reaching its technical limit (Chart I-11). As a reminder, when an investment's fractal dimension approaches its natural lower bound, it signals that excessive trend following and groupthink have reached a natural point of instability. At which point the established trend is likely to break down with or without an external catalyst. Chart I-11The Current Uptrend In The Eurostoxx600 ##br##Is Reaching Its Technical Limit Before making a large absolute commitment to the equity asset class on a 6-12 month or longer horizon, I would first like to see both of these trustworthy signals stop flashing red. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The capital key refers to the proportion of the ECB's capital owned by each of the euro area member states, and it is broadly pro-rata to the member state's GDP. 2 German GDP is 2 times the size of Italian GDP, but the stock of German sovereign debt is only 1.1 times the size of Italian sovereign debt. 3 Published on April 13 2017 and available at eis.bcaresearch.com Fractal Trading Model* The 65-day fractal dimension of nickel versus tin is approaching a level which has previously signaled an imminent trend-reversal. Go long nickel/short tin as this week's trade. Chart I-12 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. 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 - 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
Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Chart 3GOP Not Yet Willing To Impeach Trump Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four 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. Fractal Trading Model * 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 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
Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns