Europe
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights Duration: The odds of further bond bearish catalysts emerging during the next 6-12 months are still quite elevated. Maintain below benchmark duration. Global Bond Strategy: The most likely candidates for another bond bearish catalyst would be an announcement of substantial fiscal stimulus from Japan and/or a hawkish policy shift from the Fed. Investors should remain overweight core Europe, underweight U.S. Treasuries and neutral on JGBs. U.S. High-Yield: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal. Feature In a U.S. Bond Strategy Special Report1 published in August we observed that, since the financial crisis, material increases in global bond yields have all been associated with a policy catalyst (Chart 1). We identified three such catalysts: the Fed's 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013, and the European Central Bank's (ECB) announcement of its own QE program in 2015. Now we can add the election of Donald Trump as a fourth catalyst that has spurred a tantrum in global bond markets. Chart 1The Four Post-Crisis Bond Tantrums The common factor that links all of these catalysts is that each causes the market to quickly re-assess its expectations about the future pace of monetary tightening. Interestingly, this re-assessment can be caused by either the announcement of a program that is perceived to be extremely stimulative or the announcement that monetary stimulus will be scaled back. Examples of the former include both the Fed's and ECB's QE announcements as well as the recent U.S. election. An example of the latter would be the 2013 taper tantrum. As in August, the goal of this report is to perform a quick survey of the major global economies in order to assess the likelihood that another bond-bearish catalyst emerges during the next 6-12 months. While we find it difficult to see a catalyst of the same scale as those shown in Chart 1, we assign high odds to the possibility that the announcement of fiscal easing in Japan will add to the bearish pressure on global bonds. We also assign high odds to the possibility that upside inflation surprises in the U.S. cause the Fed to adopt a more hawkish forward guidance, further increasing the bearish pressure on global bonds. We assign low odds to the possibility that ECB policy will contribute to the global bond selloff. U.S. Chart 2Fed Wants Breakevens To Head Higher The recent "Trump Tantrum" has sent yields sharply higher, and expectations priced into the U.S. bond market are now not far from the Fed's median rate hike expectations, especially at the short-end of the curve (Chart 2). In the U.S., the next most likely catalyst for sharply higher global bond yields would be the Fed signaling that it will adopt a quicker pace of rate hikes. Specifically, the Fed would need to cease revising its funds rate forecasts lower - which has been the pattern for the last few years - and start revising them higher. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, the Fed will take a more cautious approach. In fact, with inflation still below target (Chart 2, bottom panel) and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but that the median expectation will continue to call for only two more hikes in 2017. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed's inflation target. This corresponds to a range of 2.4% to 2.5% on the 5-year, 5-year forward TIPS breakeven inflation rate (Chart 2, second panel). Assuming that U.S. economic growth continues to accelerate into next year, as we expect, then the 5y5y TIPS breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely. In the meantime, while the "Trump Tantrum" is likely to take a pause in the near-term (next 1-2 months), it may not have run its course just yet. If U.S. growth is strong in 2017 and the Trump administration appears to be making progress implementing its more stimulative policies, then the Treasury curve will likely resume its bear-steepening trend in the first half of next year.2 Euro Area Chart 3Strong Growth, But Plenty Of Slack According to the OECD and others, including the European Commission and ECB, trend GDP growth in the Eurozone is below 1%. In fact, most estimates center around 0.7%. This means that as long as GDP growth is maintained above these levels we should expect the labor market to continue to tighten. At least for now, the data suggest that growth is likely to remain well above trend. Led by gains in both the services and manufacturing indexes, the euro area's composite PMI jumped from 53.3 to 54.1 in November. The composite PMI has a good track record of leading European GDP growth (Chart 3), and the current reading is consistent with GDP growth of 2%. Despite strong growth, the ECB's policy stance is likely to remain accommodative for quite some time and is unlikely to spur a global bond tantrum within our 6-12 month investment horizon. The fact that core inflation remains below 1% (Chart 3, panel 3) tells us that the output gap in the euro area is still very wide. It will take a prolonged period of strong growth for the output gap to close and for inflationary pressures to mount. In prior cycles inflation has not begun to accelerate until the unemployment rate was below 9% (shaded regions in Chart 3). An announcement from the ECB that it will cease its asset purchase program because the economy has made adequate progress toward its economic and inflation goals would likely spur a large rise in global bond yields. However, this is unlikely to occur until the unemployment rate is below 9% and inflation is in an uptrend. As we argued in a recent Global Fixed Income Strategy report,3 the ECB will be able to alter the rules regarding the quantity of bonds available for purchase as is necessary to keep the program in place. Japan The Bank of Japan (BoJ) recently switched to a policy framework that involves targeting a level of yields as opposed to a quantity of purchases. In our view, this sends a pretty strong signal that monetary policy is close to being exhausted and that fiscal policy must take up the baton of Abenomics. While the timing and amount of any additional fiscal spending is not clear, it is probably necessary if policymakers are serious about reaching their 2% inflation goal. Chart 4Policy Action Required In Japan At present, the Japanese Diet is currently deliberating the third revision to the second supplementary budget and government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. While any fiscal measures would not spur an increase in nominal JGB yields (because the BoJ will retain the cap), they would spur an increase in inflation expectations and a decline in real yields (Chart 4). We also think that the reflationary impulse would be felt by bond markets in the rest of the world, and that large enough fiscal stimulus from Japan would pressure global bond yields higher even though JGBs remain capped. Admittedly, the cap on nominal JGB yields would limit the contagion from Japanese fiscal stimulus to the rest of the global bond market. As would the impact of a depreciating yen relative to the euro and U.S. dollar. However, we also suspect that the shift toward greater fiscal stimulus in both the U.S. and Japan would cause investors to revise their global growth expectations higher, and that this impact would dominate in terms of the impact on global bond yields. Investment Conclusions The odds of further bond bearish catalysts emerging during the next 6-12 months remain quite elevated. The most likely candidates would be an announcement of substantial fiscal stimulus in Japan and/or a hawkish policy shift from the Fed. The ECB is unlikely to contribute to the bearish pressure on global bonds during the next 6-12 months. As such, we continue to recommend a below benchmark duration stance on a 6-12 month horizon. In global bond portfolios, investors should remain overweight core Europe, underweight U.S. Treasuries and neutral JGBs. Valuation & Expected Returns In U.S. High-Yield A commonly used tool for assessing value in the high-yield bond market is a default-adjusted spread. That is, we formulate an expectation for default losses during our investment horizon and compare it to the spread that is currently on offer. If the current spread is elevated compared to our expectation for default losses then the default-adjusted spread is high and we would see good value in high-yield bonds relative to equivalent-duration Treasuries. This week we examine two different formulations of a default-adjusted spread for the U.S. high-yield market and test how well each corresponds to excess junk returns. The first measure we look at is a true ex-ante measure. It relies only on data that are available in real time, and can therefore be used as part of a trading strategy. Specifically, our ex-ante default-adjusted spread is calculated as the average option-adjusted spread from the Bloomberg Barclays U.S. High-Yield index less an expectation of default losses for the subsequent 12 month period. Expected default losses are calculated by taking the Moody's baseline forecast for the U.S. speculative grade default rate during the next 12 months and multiplying it by 1 minus our forecast of the recovery rate for this same period. We forecast the recovery rate based on its historical relationship with the default rate. The second measure we examine is an ex-post default-adjusted spread. In this case we look at the average spread of the index less actual default losses that are realized during the subsequent 12 months. As such, this measure can only be calculated after the fact. Comparing the ex-ante and ex-post measures, we see that both tend to reside within a range of 200 to 300 basis points. However, the ex-post measure periodically shows a negative value while the ex-ante measure is more often above 300 bps (Chart 5). This tells us that when forecasting default losses it is more common to underestimate default losses, rather than overestimate them. Chart 5Distribution of Default-Adjusted Spreads Over Time The next thing we look at is how closely each measure aligns with high-yield excess returns (Charts 6 & 7). Our ex-ante measure explains 34% of the variation in high-yield excess returns since 2002 (when our sample begins). Predictably, the ex-post measure, which removes the error surrounding the default loss forecast, explains a greater proportion of the variation in excess junk returns (53%). Our sample period is also longer for the ex-post measure, beginning in 1995. Chart 612-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 712-Month Excess High-Yield Returns Vs. ##br##Ex-Post Default-Adjusted Spread (1995 - Present) The current average option-adjusted spread for the High-Yield index is 459 bps. If we incorporate the Moody's baseline forecast for the default rate during the next 12 months (4.1%) and our forecast for the recovery rate (39%), then we calculate an ex-ante default-adjusted spread of 210 bps. Using the relationship in Chart 6, this translates into an expected 12-month excess return of -26 bps. If we assume there is no error in our forecast then we can use the relationship in Chart 7. In that case, our expected 12-month excess return would be +55 bps. Of course, that exercise imposes a linear relationship between excess returns and the default-adjusted spread and doesn't consider that there is considerable variation in actual excess returns around this trendline. For that reason, in Charts 8 & 9 we split both our default-adjusted spread measures into intervals of 50 basis points. For each interval we display the average 12-month excess return along with a 90% confidence interval for where those returns are likely to fall. Chart 812-Month High-Yield Excess Returns & 90% Confidence Intervals: ##br##Ex-Ante Default-Adjusted Spread Chart 912-Month High-Yield Excess Returns & 90% Confidence Intervals:##br## Ex-Post Default-Adjusted Spread Specifically, the blue dots in Charts 8 & 9 show the 12-month excess return that is earned on average when the default-adjusted spread falls into a particular interval. The top and bottom edges of the vertical lines correspond to the upper and lower limits of the 90% confidence interval. More statistics related to the 12-month excess returns that have been observed when the default-adjusted spread falls into a specific interval can be found in the Appendix to this report. The main message from these charts is that a default-adjusted spread below 100 bps is a powerful sell signal, while a default-adjusted spread above 350 bps is a powerful buy signal. Between those two thresholds the signal is less clear. Bottom Line: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal, but is consistent with small positive excess returns. Our inclination is to remain cautious on U.S. high-yield for the time being, but to look for opportunities to upgrade from more attractive valuations. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com Appendix Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally Chart I-42005: Commodity##br## Rally Was An Oil Rally Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Chart I-6China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds Chart I-8DM Hurting EM EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth Chart I-10The Liquidity ##br##Channel Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. Chart I-15Favorable Supply/Demand Backdrop For Oil Chart I-16A Good Entry Point For Shorting AUD/CAD Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight Chart I-18A Countertrend Move In USD/JPY Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In November, the model underperformed global equities and the S&P in USD and in local-currency terms. For December, the model reduced its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). Within the equity portfolio, most of the decrease in allocation came at the expense of EM, Sweden, Netherlands, U.S., and New Zealand. The model increased its weighting in Swedish, French, U.K., and Canadian bonds. The risk index for stocks deteriorated in November, while the bond risk index improved significantly. Chart 1Model Weights Feature Performance In November, the recommended balanced portfolio lost 1.5% in local-currency terms and was down 3.4% in U.S. dollar terms (Chart 2). This compares with a gain of 1.3% for the global equity benchmark, and a 3.7% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The sharp bond selloff and weakness in EM equity markets both took a toll on the model's performance in November. Weights The model cut its allocation to stocks from 66% to 53%, and increased its bond weighting from 26% to 47%. The allocation to cash was brought down to zero from 8%, while commodities remain excluded from the portfolio (Table 1). The model trimmed its allocation to Latin American equities by 4 points, Sweden by 3 points, and the Netherlands by 3 points. Also, weightings were reduced in U.S., New Zealand, Spanish, and Emerging Asian stocks. In the fixed-income space, the allocation to Swedish paper was boosted by 12 points, France by 7 points, Canada by 5 points, the U.K. by 3 points, and Italy by 1 point. Allocation to New Zealand bonds was decreased by 6 points and U.S. Treasurys by 1 point. Chart 2Portfolio Total Returns Table 1Model Weights (As Of November 24, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated significantly in November following the U.S. presidential election. Our Dollar Capitulation Index spiked and is currently at levels that suggest the rally in the broad trade-weighted dollar could pause (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The momentum indicator for commodities has moved further into overbought territory, pushing up the overall risk index. This asset class remains excluded from the portfolio (Chart 4). The deterioration in the liquidity and momentum indicators has lifted the risk index for global equities to the highest level in over 2 years. Our model cut its weighting in equities for the fourth month in a row (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The risk index for U.S. stocks increased sharply in November. With stocks reaching new highs, the model trimmed its allocation to this bourse. The markets took note of the growth-positive aspects of Trump's policies, but seem complacent about the stronger dollar, higher interest rates, and the potential for trade protectionist policies (Chart 6). The risk index for euro area equities has ticked up slightly in November. However, unlike its U.S. peers, it remains in the low-risk zone. Above-trend growth could provide support for euro area equities. (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk The risk index for Dutch equities ticked up slightly and the model has downgraded this asset. That said, the weighting in Dutch equities remains the highest among its euro area counterparts (Chart 8). Improvements in the value and momentum measures for Latin American stocks have been largely offset by a deteriorating liquidity reading. As a result, the risk index did not decline much after the selloff. The model decreased its allocation to this asset (Chart 9). Chart 8Dutch Stock Market And Risk Chart 9Latin American Stock Market And Risk Over the course of only a few months, the risk index for bonds has swung from an extremely high risk level to the low-risk zone. Momentum has been the primary driving force behind this move and currently suggests that yields could pull back in the near term (Chart 10). The risk index for U.S. Treasurys declined significantly in November. While the model used the latest selloff to boost its allocation to bonds, it preferred to add allocation to bond markets outside of Treasurys. (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk After the rise in yields, Canadian bonds are massively oversold based on our momentum measure. The extremely low-risk reading has prompted the model to allocate to this asset (Chart 12). German bonds are oversold, but the reading on the cyclical measure has become considerably more bund-unfriendly. The model opted not to include bunds in the overall boost to its bond allocation. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13German Bond Yields And Risk The risk reading in French bonds is more favorable than for bunds. Apart from oversold momentum, the value reading has also improved. The model increased its allocation to French bonds (Chart 14). The cyclical component of the risk index for Swedish bonds keeps moving in a bond-bearish direction. But that is completely overshadowed by extremely oversold conditions. In fact, the overall risk index for Swedish bonds is the lowest within our bond universe. Much of the increase in overall bond allocation ended up in Swedish paper (Chart 15). Chart 14French Bond Yields And Risk Chart 15Swedish Bond Yields And Risk Following sharp gains, the 13-week momentum measure for the U.S. dollar has reached levels at which some consolidation may take place. But the recovery in the 40-week rate of change measure indicates that it would probably be a pause in the dollar bull market rather than a trend change. With the December rate hike baked in, the Fed's communication about the policy next year holds the key to the path of the dollar - in addition to the fiscal policy of the next administration (Chart 16). The Japanese yen has been a major victim of the dollar rally. The 13-week momentum measure is approaching levels that halted the yen weakening trend in 2013 and 2015. However, this time around, it is not coupled with the same signal from the 40-week rate of change measure. The BoJ is sticking to its easy monetary policy, and some additional support on the fiscal front could drag the yen lower, notwithstanding a possible hiatus in the short term. Short term the yen could benefit from an EM pullback (Chart 17). After the latest bout of depreciation, the euro seems poised for another attempt to break below 1.05. The 13-week and 40-week momentum measures do not preclude this from happening. However, it would probably take the ECB to reaffirm its dovish message to push EUR/USD technical indicators into more oversold territory (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? Stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? Overweight the Eurostoxx600 versus the Nikkei 225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Underweight the Eurostoxx600 versus the S&P500. Feature 2016 is the year of the political shock. But for investors, some things have stayed faithfully the same. Chart of the WeekEurostoxx Vs. Nikkei Reduces To: Will Euro/Yen Weaken? Last week's report From Berlin Wall To Mexican Wall explained how the fall of the Berlin Wall in 1989 ushered in a great era of globalization - an era in which goods, services, capital and people have moved around the world more and more freely. Chart I-2The Globalization Of Stock Markets For investors, one major upshot is that the world's biggest companies have also become more and more globalized. The leading European stock market indexes - Eurostoxx600, FTSE100, DAX30, CAC40 and many other national indexes - are now just a collection of multinational companies with a global footprint. The same applies to major indexes outside Europe, such as the Nikkei225 and S&P500. Before the era of globalization, many companies had little exposure to economies outside their country or region of domicile. Unsurprisingly, in the 1980s, a German bank share price was more correlated with the rest of the German stock market than it was with a U.S. bank share price. But today, a large proportion of sales and profits are sourced globally. The German bank share price is now more correlated with the U.S. bank share price than it is with the rest of the German stock market! (Chart I-2) This begs the question: if Brexit and President-elect Trump are ushering in a great era of anti-globalization, will the major indexes become parochial once again? The answer is perhaps, but it will be a slow process - even assuming that the anti-globalization rhetoric does fully materialize. Sometimes, Stock Market Allocation Reduces To A Currency View For the time being, one obvious distinction between the major indexes will remain instrumental in driving performance differences. The Eurostoxx600 is denominated in euros, the FTSE100 in pounds, the Nikkei225 in yen, and the S&P500 in dollars. However, the constituent companies' sales and profits are denominated in a mixture of major global currencies, or in dollars. So all else being equal, if the local currency weakens - in other words, if other global currencies strengthen versus the local currency - then index profits will rise in local currency terms. Meaning the index value must go up. And if the local currency strengthens, the index value must go down. Simplistic as it sounds, some important asset allocation decisions just reduce to a bi-lateral currency view. Chart I-3 clearly shows that Eurostoxx600 versus FTSE100 relative performance reduces to a simple question: will the euro weaken against the pound? If so, the Eurostoxx600 will outperform the FTSE100. And vice-versa. Clearly, the outlook for euro/pound has been an important question this year, and will be an equally important question next year. Chart I-3Eurostoxx Vs. FTSE Reduces To: Will Euro/Pound Weaken? Likewise, the Chart of the Week clearly shows that Eurostoxx600 versus Nikkei225 relative performance reduces to a similar simple question: will the euro weaken against the yen? If so, the Eurostoxx600 will outperform the Nikkei225. And vice-versa. Sometimes, Stock Market Allocation Reduces To A Sector View But in the case of the Eurostoxx600 versus the S&P500, relative performance does not reduce to the direction of euro/dollar. Since mid-2014, the euro has weakened substantially versus the dollar, yet the Eurostoxx600 has underperformed the S&P500. This is because another factor drives this relative performance pair (Chart I-4 and Chart I-5). Chart I-4Eurostoxx Vs. S&P500 Does Not ##br##Depend On Euro/Dollar... Chart I-5...Eurostoxx Vs. S&P500 Does Depend ##br##On Banks Vs. Technology Although major indexes are a collection of multinational companies, it doesn't follow that the sector exposures of these indexes will be the same. Comparing the Eurostoxx600 with the S&P500, the Eurostoxx600 has a marked overexposure to Banks and an especially marked underexposure to Technology (Table I-1). Table I-1Eurostoxx Vs. S&P500 = Overweight##br## Banks, Underweight Technology Banks comprise 13% of the Eurostoxx600 market capitalization but only 6% of the S&P500. On the flipside, Technology comprises just 4% of the Eurostoxx600 market capitalization but a very substantial 21% of the S&P500. To repeat, multinational company share prices today are more correlated with their global sector than with their domestic stock market of listing. Recently, this has been true even for U.S. Banks - which amazingly have shown a higher correlation with European Banks than with the rest of the U.S. stock market. It follows that when two indexes are distinguished by large sector skews, these sector skews will drive relative performance. Our Special Reports Picking Countries The Right Way 1 Parts 1, 2 and 3 showed that this is the case for most head to head stock market comparisons within Europe. It is also the case for the Eurostoxx600 versus the S&P500. Put simply, for the Eurostoxx600 to outperform the S&P500 on a sustained basis, Banks must outperform Technology on a sustained basis. Or to be more precise, European Banks must outperform U.S. Technology (Chart I-6). Chart I-6Eurostoxx Vs. S&P500 Reduces To: Will European Banks Outperform U.S. Technology? Applying Reductionism To The Eurostoxx600 We can now apply investment reductionism to position the Eurostoxx600 against three other major indexes: the FTSE100, the Nikkei225 and the S&P500. 1. Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? For the foreseeable future, the euro/pound exchange rate hinges on the perceived severity of Brexit. In this regard, there is unlikely to be meaningful new information until the U.K. Supreme Court delivers its verdict on the legal process that the U.K. government must follow. The verdict is due in January. So for the time being, it is appropriate to stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? 2. The euro/yen exchange rate hinges on ECB/BoJ relative monetary policy. Given that the BoJ made its bold policy move a few months ago, the focus now is on whether the ECB will continue with QE beyond March 2017. Chart I-7European Banks Do Not Offer An Especially##br## Large Discount To U.S. Technology The minutes of the ECB's most recent policy meeting provide some clues. On the one hand, the central bank cautioned on the unintended consequences of extended QE: "The possible side effects of the low interest rate environment and the range of non-standard measures in place on the longer-term intermediation capacity of banks and other financial institutions had to be further examined" On the other hand, the ECB emphasised: "(QE) was set to run... in any case until the ECB saw a sustained adjustment in the path of inflation consistent with its inflation aim... underlying inflation, however, continued to lack clear signs of a convincing upward trend." On this basis, it seems that the ECB will extend its QE program beyond March 2017, as well as give a strong commitment to keep policy rates anchored. But the recent underperformance of the Eurostoxx600 versus Nikkei225 has discounted a sizable strengthening of euro/yen. It is appropriate to lean against this and overweight the Eurostoxx600 versus the Nikkei225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Again, the minutes of the ECB's most recent policy meeting perfectly summarized the environment for European banks: "Ongoing structural challenges to banks' balance sheets, notably arising from still high levels of non-performing loans (NPLs) in parts of the euro area banking sector, in conjunction with regulatory challenges (BRRD), and the weakness in profitability were seen to pose a risk to the transmission of monetary policy and a further recovery in credit dynamics" Or as we recently put it,2 European bank investors are fighting three long-term headwinds: BRRD, NPLs and NIRP. Yet on a price to forward earnings multiple, European Banks do not offer an especially large discount to U.S. Technology (Chart I-7). Therefore, investment reductionism says it is appropriate to underweight the Eurostoxx600 versus the S&P500. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Please see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015, available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report "All Roads Lead To Banks", dated October 6, 2016, available at eis.bcaresearch.com Fractal Trading Model* The recent sharp moves in markets offer another opportunity for a long plantinum / short palladium pair-trade. A similar opportunity on October 6 successfully signaled a 13% countertrend move. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome Chart 4Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives Chart 16An Inflationary Backdrop Chart 17Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.
Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades