Europe
Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The dollar continues to suffer as global growth remains strong. The year-end performance of the dollar rarely heralds things to come for the next six to twelve months. Signs are slowly accumulating that global growth may soften, but it could take a quarter to happen. In the meanwhile, the dollar could continue to weaken. Already boosted by global growth, the euro received a further fillip as markets upgraded the anticipated terminal interest rate in Europe. The U.S. terminal rate will be upgraded too, but only when this happen will the dollar be able to rally. Stay cautious. Feature As a cold snap engulfed North America, the U.S. dollar finished 2017 falling as fast as the mercury. This move is worrisome, as it pushed the greenback to the edge of a cliff. If the DXY punches below 91, the low hit on September 7, the greenback could hit 88. For EUR/USD, a decisive break above 1.21 constitutes the same threshold, and would indicate that the euro will rally to 1.25. Vigilance is required. A December Signal? The performance of the dollar in the last two weeks of December rarely offers a reliable signal of things to come. As Table I-1 illustrates, based on more than 20 years of data, the performance of the dollar index in the last weeks of a year has been negatively correlated with the dollar's performance over the following six to 12 months. This would imply that investors fighting dominating trends over the course of the prior 12 months capitulate in the last two weeks of the year, cleaning the slate in the process. Table I-1A Cold Snap Doesn't Make A Winter When it comes to specific pairs, relationships vary. The correlation of EUR/USD's subsequent six-month and 12-month returns with its year-end performance is zero, thus there is little to glean from the euro's recent strength in terms of its implications for 2018. However, interestingly, there is a strong negative correlation between the AUD/USD's year-end performance and the Aussie's returns over the next six to 12 months. It would seem the AUD's blistering rally is to be sold, not bought. The weakness in the USD was supercharged by the greenback's countercyclical nature. Our global synchronicity indictor - which measures the proportion of DM economies with PMIs above 50 - displays a negative correlation with the dollar's returns. This indicator's extraordinarily strong performance elucidates why the dollar was so weak last year, and also why the euro performed so well (Chart I-1). Going forward, two key leading indicators of our global synchronicity measure are saying that the global upswing could lose power (Chart I-2). The performance of Swedish equities relative to U.S. stocks and the annual change in U.S. 10-year yields reveal that even if global growth remains above trend, it will decelerate from current elevated readings. This could support the dollar index. However, we should keep an eye on the performance of EM carry trades.1 EM carry trades had been indicating that the best days for global growth are also behind us (Chart I-3), but lately EM carry trades have regained some vigor. If this strength is maintained, the message from the relative performance of Swedish equities and of U.S. bond yields will be invalidated. Such a move could be associated with a DXY breaking down below 91, potentially hitting 88; and EUR/USD rallying above 1.21 to 1.25. Chart I-1Strong Global Growth Hurts The Dollar Chart I-2Will This Synchronized Boom Peter Off? Chart I-3EM Carry Trades And Growth When all these forces are taken together, the picture for the dollar remains murky. The recent weakness in the Baltic Dry Index as well as the outperformance of oil relative to metals prices suggests we are entering a late cycle environment where even if global growth remain above trend, it is likely to be peaking. Thus, even if the dollar were to sell off further in the coming weeks, the downside will be limited. Nonetheless, a rally in the USD will have to wait for clear signs that U.S. inflation is picking up. It is best to stay on the sidelines for now. Bottom Line: The performance of the dollar in the last weeks of the year is rarely a good gauge of the dollar trend for the next six to 12 months. However, the dollar has been suffering on the back of strong global growth. While important metrics are suggesting that global growth could lose some momentum, other essential indicators such as EM carry trades are regaining some vigor. For now, limiting directional dollar bets is a safer strategy. The dollar will only rally once U.S. inflation picks up. EUR/USD And Terminal Rates The recent strength in the euro is linked to strong global growth. However, EUR/USD has been supercharged by domestic factors. In December, the differential in expected terminal policy rates between the European Central Bank and the Federal Reserve moved violently in favor of the euro. This move reflected a forceful upgrade of the anticipated terminal policy rate in the euro area (Chart I-4). This sudden upgrade in Europe makes sense: the European economy is strong. Euro area PMIs are at record highs, German unemployment has hit post-unification lows and German inflation regained gumption. Moreover, Benoit Coeure, a member of the ECB's Executive Board, expressed some very hawkish views. The market is correct to upgrade the outlook for the ECB. However, interest rate markets continue to expect too-shy-a-Fed over the remainder of the cycle. This leaves room to upgrade the expected terminal interest rate for the U.S. The U.S. economy is also firing on all cylinders. The U.S. ISM came in at 59.7 this week, with the new order component standing at a very strong 69.4. Additionally, total hours worked have been accelerating (Chart I-5). Together, these point to very robust GDP growth. Already, the Atlanta Fed GDPNow tracker foresees growth of 3.2% for Q4. Chart I-4EM Carry Trades And Growth Chart I-5U.S. Growth Set To Accelerate Strong U.S. growth is materializing in an environment of increasingly significant capacity constraints, which has historically been associated with rising inflationary pressures (Chart I-6). The recent easing in U.S. financial conditions only reinforces this message, and argues that U.S. inflation has upside (Chart I-7). Moreover, U.S. compensation costs have been accelerating, from a low of 1.9% in 2016 to 2.5% today. Hence, U.S. inflation should perk up this year, letting the Fed increase rates more than what markets currently foresee. Chart I-6Inflationary Backdrop In The U.S. Chart I-7U.S. Financial Conditions Furthermore, the relative growth picture indicates that the increase in U.S. terminal rate should outpace the eurozone's. The Goldman Sachs Current Activity Indicator in the euro area has rolled over relative to the U.S., highlighting that the euro has tightened relative financial conditions enough to now harm the growth profile of Europe vis-Ã -vis the U.S. (Chart I-8). Moreover, European economic surprises are slowing sharply relative to the U.S. and the Euro Stoxx is re-testing its cycle low against the S&P 500, further corroborating the message from the Current Activity Indicator (Chart I-9). Chart I-8EUR/USD Starting To Hurt European ##br## Relative Growth Prospects Chart I-9Strains In The ##br##Eurozone Despite these dynamics, it is not clear that making a bet today on a weak euro is the proper tactic. At the time of writing, EUR/USD was flirting with its previous high of 2017; any break above 1.21 would likely push EUR/USD toward 1.25. Thus, we recommend investors continue to play pairs like short EUR/SEK to take advantage of the tightening in euro area financial conditions rather than bet outright on EUR/USD. To make this latter bet, investors will need either a marked failure of EUR/USD to break out, thus invalidating previous bullish technical signals, or a pick-up in U.S. inflation, whose timing remains unclear. Bottom Line: The euro's rally has been supercharged by an upgrade of the market's expected terminal policy rates in Europe relative to the U.S. While upgrading the ECB makes sense, markets should also upgrade the U.S. policy path as the American economy is just as strong and closer to capacity constraints, thus more likely to generate inflation. However, fighting the momentum in EUR/USD is currently dangerous. Thus, we recommend investors to wait for U.S. inflation to pick up before selling the euro. Instead, sell EUR/SEK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive: Personal consumption expenditure and core personal expenditure grew at 1.8% YoY and 1.5% YoY respectively. Both measures increased from last month's reading. ISM manufacturing PMI came in at 59.7, surprising significantly to the upside. This measure also increased from last month. Meanwhile, ISM prices paid came in at 69, smashing expectations. The dollar ended 2017 on a free fall, as the enigma of low inflation in an environment of very low unemployment continues to puzzle investors. Meanwhile global growth continues to be very strong, adding an additional handicap to the dollar. We continue to believe that the Fed will hike more than expected, pushing the dollar upwards. However for this process to star, inflation must first emerge in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in Europe has been positive: M3 Money supply yearly growth surprised to the upside, coming in at 4.9%. Moreover, Europe's Markit manufacturing PMI, came in line with expectations at 60.6. Finally, Germany's headline inflation also outperformed expectations, coming in at 1.6%. However this number did decline from the previous month. EUR/USD has rallied by almost 2% since Christmas. This has been mainly due to the rhetoric by ECB members, who appear to be much less dovish than before. Indeed, ECB board member Mersch warned that the ECB "must be careful not to act too timidly and too late and to fall behind the curve". Overall, we continue to believe that the Fed will surprise the market more than the ECB will. However to have an outright bullish dollar view inflation will have to pick up in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Retail trade yearly growth came in at 2.2%, exceeding expectations by a wide margin. Meanwhile, housing starts also surprised to the upside, as they contracted by only 0.4%. Tokyo CPI ex fresh food yearly growth also beat expectations, coming in at 0.8%. Finally, the unemployment rate declined to 2.7%. The yen has appreciated against the U.S. dollar, with USD/JPY falling by about 0.7%. Meanwhile, Kuroda continued to assert that no change is needed to the BoJ's yield curve control program. Overall, in spite of the improved global outlook which is benefiting the Japanese economy, it is unlikely that Japan will abandon its extremely dovish monetary policy unless inflation rises much further. This is unlikely to happen in the near future. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Gross domestic product growth surprised to the upside, coming in at 1.7%. However this number did decline from the previous quarter. Additionally, total business investment yearly growth also outperformed expectations, coming in at 1.7%. However, Markit manufacturing PMI underperformed expectations, coming in at 56.3. Moreover, construction PMI also surprised to the downside, coming in at 52.2. Since Christmas, cable has gone up by roughly 1.5%. Overall we believe that the BoE is unlikely to raise rates meaningfully, as they will be more cautious than otherwise as the U.K. muddles through the Brexit negotiations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Private sector credit yearly growth increased relatively to last month, coming in at 5.4%. However the AiG Performance of Manufacturing Index declined relatively to last month, coming in at 56.2 in December versus 57.3 in November. Finally, the RBA Commodity SDR Index, which in an early indicator of export price changes, contracted by 5.9%, a decline from last month's 4% contractions. The Australian dollar has rallied by more than 2.6% since Christmas, as multiple indicators point to continued strength in global growth. However we expect a temporary slowdown, as a result of tightening financial conditions in China. This will be negative for the AUD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has increased by roughly 1.2% since Christmas, partly because of the decline of the U.S. dollar. However the New Zealand dollar has depreciated against almost every single G10 currency. Overall, we expect the NZD to appreciate relative to the AUD, given that the Australian dollar is much more sensitive to Chinese tightening financial conditions. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Gross Domestic Product month-on-month growth underperformed expectations, coming in at 0%. However, Markit manufacturing PMI surprised to the upside, coming in at 54.7. This measure also increased relatively to last month's. USD/CAD has plunged by nearly 2.8%. We expect the Canadian dollar to outperform the AUD and the NZD, as oil should outperform metals in the commodity space. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator surprised to the upside, coming in at 111.3 in December. This measure also increased relative to November's reading. Meanwhile, the SVME Purchasing Manager's Index also outperformed expectations, coming in at 65.2. Finally, the ZEW survey expectations component increased relatively to last month, coming in at 52. EUR/CHF has continued its appreciation into the New Year. This is good news for the SNB, as this will provide an easing in financial conditions. Overall, we expect the franc to have limited downside against the euro, as the still low inflation in Switzerland will keep the SNB intervening in currency markets. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth for November increased relatively to last month's number, coming in at 2.1%. However, registered unemployment surprised negatively, as it increased from 2.3% to 2.4%. Since Christmas, USD/NOK has plunged by nearly 3%, as it has been battered by very strong oil prices. Overall, we expect USD/NOK to find upside, however this will happen only when rate expectations in the U.S. rise meaningfully. In order for this to happen, inflation must once again accelerate. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.8%. This measure also increased from last month's reading. Producer price inflation also increased from last month's number, coming in at 2.7%. However, Manufacturing PMI declined in December relatively to November, coming in at 60.4. In line with multiple indicators signaling that global growth continues to improve, USD/SEK has plunged by more than 2.5% since Christmas. Investors willing to bet on a temporary slowdown in the euro area, caused by tightening financial conditions should short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Chart 1BPositive Global Growth Momentum Can Be Seen Here Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Chart 9Surveys Are Signaling Acceleration ##br## In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 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. * 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
Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 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. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 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 BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.
Highlights 2018 Model Bond Portfolio Positioning: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Country Allocations: Divergences in likely central bank policy moves in 2018 will lead to more cross-country bond market investment opportunities. In our model portfolio, we are maintaining underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and adding small overweights in the U.K. and Australia (where rate hikes are unlikely). Spread Product: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Feature Two weeks ago, we published our "Key Views" report, outlining the main fixed income investment implications deriving from the 2018 BCA Outlook.1 In this, our final report of 2017, we translate those Key Views into direct allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. As we always remind our clients, our model portfolio is intended as a vehicle to communicate our opinions on the relative attractiveness and trade-offs between fixed income countries and sectors. That is to say, the portfolio not only includes our traditional individual country and sector recommendations, but attaches actual weightings to those views within a fully invested hypothetical bond portfolio. The main takeaway from our Key Views is that bond market performance, and ideal asset allocation, is likely to look very different as the year progresses (Table 1). The first half of the year will see continued strong global growth and slowly rising inflation, but with central banks only slowing shifting to a less accommodative policy stance. This will create an environment where global bond yields will rise but with credit markets outperforming government bonds. The story will play out differently in the latter half, however, as worries over global growth expectations for 2018 will create more market volatility - albeit with lower cross-asset correlations as central banks act in a less-coordinated fashion than in recent years. Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Top-Down Bond Portfolio Implications Of Our Key Views The main predictions for 2018 in our Key Views report from December 5th were the following: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. The first step in translating these themes into allocations into our model bond portfolio is to determining the ideal top-down asset allocation parameters for the start of the 2018: Maintain a moderate overall level of portfolio risk. Both bond yields (Chart 1) and credit spreads (Chart 2) are at the low end of their historical ranges since 2000. This suggests that bond market returns will be much lower than in recent years, simply because initial valuations are not cheap. Coming at a time when bond volatility is also at historically depressed levels, and with central banks starting to slowly take away the monetary punch bowl, keeping overall portfolio risk at modest levels is prudent. Within the GFIS model bond portfolio, that means keeping our tracking error versus our custom benchmark performance index well below our maximum target level of 100bps (Chart 3). Chart 1Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 Chart 2Historical Range Of Global Credit Spreads, 2000-2017 Maintain a below-benchmark overall portfolio duration. The combination of solid global growth, rising inflation and a slower pace of bond buying by the major central banks all suggest that bond yields will move higher in 2018. We will continue to target a recommended portfolio duration that is one year short versus our benchmark index (Chart 4). Chart 3Maintain Moderate Overall Portfolio Risk Chart 4Stay Cautious On Duration Risk Maintain an overweight stance on corporate credit over government bonds, focusing on the U.S. Although spreads are tight in so many asset classes, the global growth and monetary backdrop remains supportive for the outperformance of credit over government bonds. We recommended focusing on U.S. corporate credit, both Investment Grade (IG) and High-Yield (HY), where growth momentum remains solid and Fed policy is not yet restrictive. After setting those broad portfolio parameters, our recommendations get more interesting in terms of country allocations. Bond yields within the developed markets have become highly correlated to inflation expectations in the past few years (Chart 5). This is no surprise given how strongly central banks have tied their monetary policy decisions to their own inflation forecasts, and to market-based and survey-based inflation expectations. Inflation is likely to move higher next year alongside tight global labor markets and higher oil prices. If the bullish views on oil from BCA's commodity strategists comes to fruition, this implies that both market-based inflation expectations can rise and yield curves can bear-steepen. The key to the latter will be how fast central banks respond to faster rates of inflation. Yield curve steepness remains highly correlated to the level of REAL interest rates. Curves steepen when real interest rates decline and vice versa. Lower real rates can happen in two ways - bullishly, if central banks cut policy rates faster than inflation is falling; or bearishly, if central banks do not hike rates as fast as inflation is rising. We see the latter as being the likely story in 2018, which will lead to steeper government bond yield curves but through higher yields and rising inflation expectations. In Chart 6, where we plot the level of real central bank policy rates (deflated by 10-year CPI swaps as a measure of inflation expectations) vs. the 2-year/10-year bond yield curves. If global inflation expectations merely follow the path implied by our bullish oil forecast (Brent crude average $65/bbl in 2018), and central banks did not respond with rate hikes, then this would generate lower real interest rates (the "x" in each panel of the chart) and steepening pressure on yield curves. Chart 5Bond Yields In 2018 Will Be Driven More##BR##By Inflation Expectations Chart 6Steepening Pressure On Yield Curves##BR##From Inflation In 2018 We don't see all central banks responding the same way to an oil-driven move higher in inflation. Lower unemployment rates, and other measures of diminished economic slack, will be needed to give policymakers confidence that their economies can tolerate higher interest rates. Judging central banks along these lines will create more interesting country bond allocation decisions in 2018 (Chart 7). Specifically, we see a greater likelihood that the Fed and Bank of Canada (BoC) can actually raise interest rates next year. It will be much harder for the Bank of England (BoE) to raise rates given sluggish domestic economic growth, lingering Brexit uncertainty and the fact that market-based inflation expectations have already peaked. The Reserve Bank of Australia (RBA) will also be unable to hike rates next year given the lack of core inflation pressures and with an unemployment rate that is still much higher than previous cyclical troughs. This leads us to add moderate portfolio overweights in the U.K. and Australia to the government bond portion of our model bond portfolio, while maintaining our current underweight stances for the U.S. and Canada (Chart 8). The ECB and Bank of Japan (BoJ) will be nowhere near a point where interest rate hikes would be considered, although the decisions those banks make with their asset purchase programs will be a bigger issue for their bond markets in 2018. Chart 7Tight Labor Markets Will##BR##Influence Bond Returns Chart 8Monetary Policy Divergences##BR##Will Drive Country Allocation Bottom Line: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. The Asset Allocation Implications Of Slower Central Bank Asset Purchases The big risk factor for global bonds in 2018 will be how markets respond to less buying from the Fed, ECB and BoJ. As the growth rate of the expansion of the major balance sheets slows, bond yields have the potential to rise through two channels: higher term premia on longer maturity bonds and the market pulling forward the expected future path of interest rates. This will become a major issue for Euro Area bond markets in the 2nd half of 2018, as the ECB will be forced by strong domestic growth and rising inflation pressures to announce a full taper of its asset purchase program by the end of 2018. This will come on top of a slower pace of buying by the BoJ (who is now targeting a price target on bond yields rather than a quantity target), and the Fed allowing some run off of its massive balance sheet. The result is that the growth rate of the major developed market central bank balance sheets is likely to slow to a low single-digit pace in 2018 (Chart 9), creating upside potential for global yields. The case for significant underweights in Euro Area fixed income will be much stronger later next year when the ECB will be forced to prepare the market for a taper. But in the first half of 2018, the impact of the ECB's purchases will continue to dampen Euro Area bond yields. At the same time, Japanese yields will remain pegged near 0% by BoJ buying. In terms of our model bond portfolio, we are maintaining an overweight stance on low-beta Japan given our views on rising global bond yields, while keeping aggregate Euro Area bond weightings close to neutral (and looking to go more aggressively underweight later in the year as the ECB taper talk ramps up). Bond markets that are less propped up by ultra-accommodative central banks will create a more volatile market backdrop for global fixed income as the year progresses. That is hardly a provocative statement, of course, given the starting point of utterly low realized bond market volatility (Chart 10). As discussed earlier, our views for 2018 lead us to recommend a more moderate portfolio risk level in 2018. The potential for higher central-bank driven market volatility fits with that expectation. Chart 9Global Yields Will Rise As##BR##Central Banks Buy Fewer Bonds Chart 10The Low Bond Vol Regime##BR##Looks Stretched A slower pace of central bank bond buying also has another implication for portfolio construction. With the wave of central bank liquidity becoming a less dominant factor, cross-asset correlations should diminish. We can see that by looking at the average correlation between sectors within our model bond portfolio benchmark index (Chart 11). We have found that the correlation is itself highly correlated to the breadth of global economic growth, as measured by our leading economic indicator diffusion index (top panel). But the average correlation is also linked to the growth rate of central bank balance sheets (bottom panel), which is a by-product of massive asset purchases reducing global macroeconomic risks and forcing investors to plow into similar asset classes to chase acceptable returns. Slightly less coordinated global growth, and less active central banks, should result in lower market correlations in 2018. At the same time, as central banks shift to a less accommodative stance - especially in the U.S. - the uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart 12). This will likely lead us to cut our recommended overweight allocations to U.S. IG and HY corporate debt in our model portfolio later in 2018. To begin the year, however, we are keeping an overweight stance until the Fed is forced to signal a shift to a more hawkish stance because of rising U.S. inflation. Chart 11Expect Lower Global Bond##BR##Correlations In 2018 Chart 12The Link Between U.S. Growth,##BR##Bond Vol & Credit Spreads Bottom Line: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Summing It All Up Chart 13Aiming For Moderate Carry##BR##In Our Model Portfolio On Page 12, we show our model bond portfolio allocations after making some changes to reflect our key views for 2018. We are doing some tweaks to our existing recommendations: modestly increasing our overweight U.S. IG corporates allocation at the expense of U.S. Treasuries; reducing our underweight in the Euro Area by reducing the large Italy underweight; adding exposure to the U.K. and Australia; while cutting our large overweight in Japan. The latter was there as a desire to get more defensive on the portfolio's duration stance, but having such a large allocation has left our portfolio with no yield advantage versus the custom benchmark index (Chart 13). With the changes we are making this week, the model bond portfolio will have a yield that is 12bps over that of our custom index. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns