Fixed Income
Highlights Duration: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019. But with market-implied rate hike expectations still depressed, we are inclined to maintain below-benchmark portfolio duration. Yield Curve: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Spread Product: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Feature So far this year the Bloomberg Barclays Treasury index has returned -2.2% in absolute terms and -3.7% versus cash (Chart 1). If the year ended today, it would go into the books as the worst year for excess Treasury returns since 2009. Chart 1A Year To Forget Taking stock of this poor bond market performance makes us wonder what might prompt a reversal of fortunes. Our golden rule of bond investing tells us that if the economic outlook worsens enough for the market to discount a slower pace of Fed rate hikes, then bond market performance will improve.1 But with the market priced for only 63 bps of rate hikes during the next 12 months, we are reluctant to make that bet today. That being said, it also seems likely that U.S. GDP growth will slow as we head into the New Year. At the very least, the intensity of the bond market sell-off should diminish as well. Peak Growth There are two reasons why we think U.S. growth will soften during the next few quarters. The first is that global economic growth (excluding the U.S.) has already slowed. In past reports we demonstrated that weak foreign economic growth tends to pull down the U.S., rather than strong U.S. growth pulling up the rest of the world.2 While recent U.S. data show only tentative signs of contagion from the rest of the world, we also see no evidence of moderation in the global growth slowdown.3 The Global Manufacturing PMI fell to 52.1 in October, a far cry from its early-2018 peak above 54 (Chart 2). The percentage of countries with PMIs above the 50 boom/bust line also fell to 74% in October, down from its 2018 high of 95%. Chart 2The Global Growth Slowdown Continues... Considering the major economic blocs, the global growth slowdown continues to be driven by Europe and China (Chart 3). The Eurozone aggregate PMI remains above 50, but is falling rapidly. Meanwhile, the Chinese PMI is threatening to break below 50, and will probably do so during the next few months. The full slate of U.S. import tariffs have still not been implemented, and in the background, leading indicators of Chinese economic activity remain soft (Chart 4). Chart 3...Driven By Europe And China Chart 4Chinese Economy Keeps Slowing The second reason why U.S. growth is likely to slow during the next few quarters is the waning impact from fiscal stimulus. With the Democrats taking control of the House following last week's midterm elections, any hopes for another round of tax cuts should be quickly dashed. There is probably room for compromise between the two parties on infrastructure spending, but it will take some time (possibly the better part of two years) for them to reach an agreement. Meanwhile, the IMF estimates that fiscal policy will shift from adding 1% to GDP growth in 2018 to only 0.4% next year (Chart 5). Chart 5Less Boost From Fiscal In 2019 Bottom Line: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019, but at this point it is not clear whether growth will slow sufficiently for the Fed to deviate from its +25 bps per quarter rate hike pace. With the market only priced for 63 bps of rate hikes during the next year, below-benchmark portfolio duration remains warranted. We prefer to position for slowing U.S. growth by taking less credit risk, maintaining only a neutral allocation to spread product with an up-in-quality bias. The Increasing Attractiveness Of Shorter Maturities Chart 1 shows a fairly consistent bearish trend in the bond market: at no point in 2018 were Treasury index returns in the black. But this doesn't mean that nothing has changed in the Treasury market this year, far from it. In fact, this year's bear-flattening of the yield curve has shifted the sweet spot for Treasury investors from the 5-year/7-year maturity point to the 2-year maturity point (Chart 6). This is true both in absolute and duration-neutral terms. Chart 6Par Coupon Treasury Curve Absolute Returns As can be seen in Chart 6, at the beginning of the year the steepest part of the Treasury curve ended at around the 5-year/7-year maturity point. Today, the curve flattens off considerably after the 2-year maturity point. This change in shape has important implications for the amount of return investors can earn from rolling down the yield curve. Table 1 shows expected 12-month returns for 2-year, 5-year and 10-year Treasury notes in three different scenarios. A scenario where the yield curve is unchanged during the next year, one where all yields rise by the average of historical 12-month yield increases, and one where all yields decrease by the average of historical 12-month yield declines. Table 1Bullish And Bearish Scenarios At Different Points Of The Curve In the unchanged yield curve scenario, expected returns are equal to "carry" which is simply the sum of the coupon income from the note (yield pick-up) and the capital gains earned from rolling down the curve (roll-down). It is in the roll-down component where the changing shape of the yield curve is most apparent. At the beginning of the year, an investor in the 5-year Treasury note could expect to earn 40 basis points of roll-down on a 12-month investment horizon, whereas an investor in the 2-year note would only earn 13 bps. But today, there is 21 bps of roll-down embedded in the 2-year note and only 6 bps in the 5-year. The end result is that we would actually expect the 2-year note to outperform the 5-year note in an unchanged yield curve environment, and only deliver 15 bps less return than the 10-year note. Charts 7A and 7B show that this sort of attractiveness in the 2-year note is quite rare. The 2-year does not usually offer more carry than the 5-year or 10-year, and periods when it does tend to coincide with an inverted yield curve. Since an inverted yield curve is a reliable predictor of recession, it usually makes sense to extend duration and favor long maturity Treasuries in those environments. This is because yields are likely to fall as the Fed cuts rates to fight the recession. But in the current environment, if recession is avoided during the next 12 months - as is our expectation - and Treasury yields continue to drift higher, a strategy of favoring the 2-year note will pay off handsomely. Chart 7AMore Carry In The 2-Year Note I Chart 7BMore Carry In The 2-Year Note II This is further elucidated by the bull and bear cases shown in Table 1. In the bearish scenario where each point on the yield curve rises by its historical 12-month average (the average is calculated only for periods when yields actually increased), the 2-year note still has a positive expected return. More importantly, the 2-year note offers an expected return that is 215 bps greater than the expected return from the 5-year note. At the beginning of the year, the 2-year note only offered 161 bps more expected return than the 5-year note in the bearish bond scenario. Similarly, in the bullish bond scenario, the 2-year note is only expected to lag the 5-year note by 228 bps. At the beginning of the year, the 2-year would have been expected to lag the 5-year by 297 bps in the bullish bond scenario. In other words, from an absolute return perspective the 2-year Treasury note is the most attractive part of the yield curve. The 2-year will outperform other maturities by more than usual in a rising yield scenario and underperform by less than usual in a falling yield scenario. This alluring combination of risk and reward looks even more enticing when coupled with our preference for keeping portfolio duration low. In Duration-Neutral Terms We do not typically look at expected total returns for specific maturity points. Rather, we prefer to separate the portfolio duration call from the yield curve positioning call. In other words, we communicate our view on the level of rates through our portfolio duration recommendation and then consider which parts of the yield curve look most attractive in duration-neutral terms. To do this, we look at butterfly spreads. Chart 8 shows that the 2/5/10 butterfly spread - the spread between the 5-year bullet and a duration-matched 2/10 barbell - has turned negative. This is unusual outside of environments where the 2/10 slope is inverted. In fact, our fair value model for the 2/5/10 butterfly spread is based on the slope of the 2/10 Treasury curve and it currently flags the 5-year bullet as expensive (Chart 8, bottom panel).4 Chart 8The 5-Year Bullet Is Expensive... In contrast, the 2-year bullet is the cheapest it has been since 2005 relative to the 1/5 barbell (Chart 9). This means that the 1/5 slope would have to flatten dramatically for returns in the 1/5 barbell to overcome the carry advantage in the 2-year note. For this reason we closed our prior yield curve position - long the 7-year bullet and short the 1/20 barbell - in last week's report, and entered a position long the 2-year bullet and short the 1/5 barbell. Chart 9...But The 2-Year Bullet Is Cheap Bottom Line: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Short Maturity Spread Product Given that the sweet spot on the yield curve has shifted from the 5-year/7-year maturity point to the 2-year maturity point, we thought we should also examine which spread products offer attractive opportunities to earn extra compensation at the short-end of the curve, as an alternative to simply buying the 2-year Treasury note. Table 2 shows the spread per unit of duration offered by different high-quality (Aaa/Aa rated), low maturity (1-3 year) spread products. We exclude non-Agency CMBS and Agency MBS because the spread volatility in those sectors makes them riskier than their credit ratings imply. Table 21-3 Year Maturity Aaa/Aa-Rated Spread Products Auto loan ABS and Aa-rated corporate bonds offer the most spread pick-up per unit of duration, but we see some potential for spread widening in both sectors. Corporate spreads could widen as profit growth falls below the rate of debt growth during the next few quarters and consumer ABS spreads might also have upside. The consumer credit delinquency rate is rising, and banks are tightening standards lending standards (Chart 10). Chart 10Some Upside In Consumer ABS Spreads Agency CMBS and Foreign Agencies both offer 17 bps of spread per unit of duration. Of those two sectors we prefer Agency CMBS, which look very attractive on our Bond Map.5 Foreign Agencies also look attractive on our Map, but could struggle as the U.S. dollar appreciates making dollar debt more difficult for foreign borrowers to service. Of all the sectors listed in Table 2, the 15 bps spread per unit of duration offered by Local Authority debt looks most alluring. Largely composed of taxable municipal issues, Local Authority debt is insulated from weakness abroad and still offers a reasonably attractive spread pick-up. Bottom Line: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 While U.S. data remain very strong, the low contribution of nonresidential investment spending to overall GDP growth in Q3 could be a sign of contagion from the rest of the world. For further details please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For further details on our butterfly spread models, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Toxic Combination", dated November 6, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Falling Oil Prices & Bond Yields: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. ECB Corporate Bond Purchases: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days in this cycle for European corporate credit are behind us, as the ECB will not treat its corporate bond purchases any differently than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade & high-yield. Feature Are Falling Oil Prices Telling Us Something About Global Growth? Thus far in November, global financial markets have reversed some of the steep losses incurred during the "Red October" correction. This has occurred for U.S. equities (the S&P 500 fell -8% last month but has risen +4% so far this month), U.S. corporate bonds (high-yield spreads widened +71bps last month and have tightened -19bps this month) and emerging market hard currency debt (USD-denominated sovereign spreads widened +27bps last month and have tightened -9bps this month). One market that has not rebounded, however, is oil. The benchmark Brent oil price fell -11% in October, but has fallen another -7% in November. This has been enough to nearly wipe out the entire +20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil markets in recent years. Such a large decline in the oil price as has been seen of late would typically result in sharp drop in government bond yields, driven by falling inflation expectations. That correlation has been holding up in the major economies outside the U.S., where nominal yields and inflation expectations are lower than the levels seen before the October peak in oil prices. Nominal U.S. Treasury yields, by contrast, remain resilient, despite the fall in TIPS breakevens (Chart of the Week). This is because real Treasury yields have been climbing higher as investors acquiesce to the steady hawkish message from the Fed by making upward revisions to the expected path of U.S. policy rates. Chart of the WeekShifting Correlations The biggest impediment holding back a full recovery of the October losses for global risk assets is uncertainty over the global growth outlook. While the U.S. economy continues to churn along at an above-trend pace, there are signs that tighter monetary policy is starting to have an impact. Both housing and capital spending have cooled, although not yet by enough to pose a terminal threat to the current long business cycle expansion. The outlook for growth outside the U.S. is far more muddled, adding to investor confusion. China has seen a clear growth deceleration throughout 2018, but the recent reads from imports and the Li Keqiang index suggest that growth may be stabilizing or even modestly re-accelerating (Chart 2). Our China strategists are not convinced that this is anything more than a ramping up of imports and production in advance of the full imposition of U.S. trade tariffs, especially with Chinese policymakers reluctant to deploy significant fiscal or monetary stimulus to boost growth. Chart 2Mixed Messages On Growth A similar mixed read is evident in overall global trade data. World import growth has also slowed throughout 2018, but has shown some stabilization of late (second panel). A similar pattern can be seen in capital goods imports within the major developed economies. Our global leading economic indicator (LEI) continues to contract, but the pace of the decline has been moderating and our global LEI diffusion index - which measures the number of countries with a rising LEI versus those with a falling LEI - may be bottoming out (third panel). There are also large, and growing, divergences within the major developed economies. The manufacturing purchasing managers' indices (PMIs) for the euro area and the U.K. have been falling steadily since the start of the year, but the PMIs have recently ticked up in the U.S. and Japan (Chart 3). A similar pattern can be seen in the OECD LEIs, which have retreated from the latest cyclical peaks by far more in the U.K. (-1.6%) and euro area (-1.2%) than in the U.S. (-0.3%) and Japan (-0.6%). Chart 3Diverging Growth, Diverging Bond Yields With such mixed messages from the macro data, investors understandably lack conviction. The backdrop does not look soft enough yet to threaten global profit growth and justify sharply lower equity prices and wider corporate bond spreads. Yet the growth divergences between the U.S. and the rest of the world are intensifying, creating a backdrop of rising U.S. real interest rates and a stronger U.S. dollar. That combination is typically toxic for emerging markets, but the impact of that would be muted this time if China were to indeed see a genuine growth reacceleration. This macro backdrop lines up with our current major fixed income investment recommendations. We suggest only a neutral allocation to global corporate bonds given the uncertainty over growth, but favoring the U.S. over Europe and emerging markets given the clearer evidence of a strong U.S. economy. At the same time, we continue to recommend below-benchmark overall portfolio duration exposure, but with regional allocations favoring countries where central banks will have difficulty raising interest rates (Japan, Australia, core Europe, the U.K.) versus nations where policymakers are likely to tighten monetary policy (U.S., Canada). However, the latest dip in oil should not be ignored. A more sustained breakdown of oil prices could force us to downgrade corporate bonds and raise duration exposure - if it were a sign that global growth was slowing and inflation expectations had peaked. The current pullback in oil has occurred alongside a decelerating trend in global economic data surprises, after speculators had ramped up long positions in oil and prices were stretched relative to the 200-day moving average (Chart 4). This suggests that the latest move has been corrective, and not a change in trend, although the burden of proof now falls on the evolution of global growth, both in absolute terms and relative to investor expectations. Chart 4Oil Correction Or Growth Scare? Bottom Line: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. European Corporates Are About To Lose A Major Buyer Last week, we published a Special Report discussing the ECB's options at next month's critical monetary policy meeting.1 One of our conclusions was that the central bank will deliver on its commitment to end the new purchases phase of its Asset Purchase Program (APP) at year-end. The bulk of the assets in the APP are government bonds, but the ECB has also been buying corporate debt in the APP since June 2016. The ECB is set to end those purchases at the end of December, to the likely detriment of euro area corporate bond returns. The Corporate Sector Purchase Program (CSPP), as it is formally known, has been a targeted tool used by the ECB to ease financial conditions for euro area companies. This has occurred through three main channels: tighter corporate bond spreads, greater access for companies to issue debt in the corporate primary market, and increased bank lending to non-financial corporations. The CSPP was intended to complement the ECB's other monetary stimulus measures, like negative interest rates and the buying of government debt. The first CSPP purchases were made on June 8, 2016. The euro area corporate bond market responded as expected, with investment grade spreads tightening from 128bps to 86bps by the end of 2017. There were spillovers into high-yield bonds, as well, with spreads falling -129bps over the same period (Chart 5). Since then, however, spreads have steadily widened and European corporates have underperformed their U.S. equivalents. This suggests that some of the relative performance of euro area credit may have simply reflected the relative strength of the euro area economy compared to the U.S. The greater acceleration of euro area growth in 2017 helped euro area corporates outperform U.S. equivalents, while the opposite has held true in 2018. Chart 5ECB Buying Does Not Control European Credit Spreads The CSPP has operated with a defined set of rules governing the purchases. Bank debt was excluded, as were bonds rated below investment grade. Only debt issued by corporations established in the euro area were eligible for the CSPP, although bonds from euro-based companies with parents who were not based in the euro area were also eligible. The latest update on the holdings data from the ECB shows that there are just under 1,200 bonds in the CSPP portfolio. Yet despite the ECB's best efforts to maintain some degree of portfolio diversification, the impact of the CSPP on euro area corporate bond markets was fairly consistent across countries and sectors (Chart 6). Italy is the notable diverging country this year, as the rising risk premiums on all Italian financial assets have pushed corporate bond yields and spreads well above the levels seen in core Europe, even with the ECB owning some Italian names in the CSPP. Chart 6Spread Convergence During CSPP There was also convergence of yields and spreads among credit tiers during the first eighteen months of the CSPP, with valuations on BBB-rated debt falling towards the levels on AA-rated and A-rated bonds (Chart 7). That convergence has gone into reverse in 2018, with BBB-rated spreads widening by +55bps year-to-date (this compares to a smaller +25bps increase in U.S. BBB-rated corporate spreads). A surge in the available supply of BBB-rated euro area bonds is a likely factor in that spread widening, as evidenced by the sharp rise in the market capitalization of the BBB segment of the Bloomberg Barclays euro area corporate bond index (top panel). Chart 7A Worsening Supply/Demand Balance For European BBBs? More broadly, the CSPP has helped the ECB's goal of boosting the ability of European companies to issue debt in primary bond markets. Traditionally, European firms have used bank loans as their main source of borrowed funds, with only the largest firms being able to issue debt in credit markets. That has changed during the CSPP era. According to data from the ECB, gross debt issuance by euro area non-financial companies (NFCs) has risen by €104bn since the start of the CSPP, taking issuance back to levels not seen since 2014 (Chart 8). The bulk of the issuance has been in shorter-maturity bonds, but there has been a notable increase in the issuance of longer-dated debt since the CSPP began. Chart 8Bank Funding Versus Bond Funding The ECB's role as a marginal buyer of bonds in the primary, or newly-issued, market has helped boost that gross issuance figure. The share of bonds that the ECB owns in the CSPP that was issued in the primary market has gone from 6% soon after the CSPP started to the current 18% (Chart 9). The growth in euro area non-financial corporate debt went from 6% to over 10% during the peak of the CSPP buying between mid-2016 and end-2017, but has since decelerated to 7%. At the same time, the annual growth in loans to NFCs, which was essentially zero during the first eighteen months of the CSPP, has accelerated to 2% over the course of 2018. Chart 9More Bank Loans, Less Debt Issuance In other words, euro area companies had been substituting bank financing for bond financing in the CSPP "era", but have since shifted back towards bank loans in 2018. That shift in financing was most notable among CSPP-eligible companies, particularly those smaller firms that had not be able to issue debt in the primary market pre-CSPP, according to an ECB analysis conducted earlier this year.2 From the point of view of the investible euro area corporate bond market, however, even larger companies that have done that shift in bank financing to bond financing have seen no noticeable increase in aggregate corporate leverage. In Chart 10, we show our bottom-up version of our Corporate Health Monitor (CHM) for the euro area. This indicator is designed to measure the aggregate financial health of euro area companies using financial ratios incorporating actual data from individual companies. We separated out the list of companies used in that CHM that are currently held in the CSPP portfolio and created a "CSPP-only" version of the CHM (the blue lines in all panels). All issuers that were eligible for inclusion in the CSPP, but whose bonds were not actually purchased by the ECB, are used to create a "non-CSPP" CHM (the black dotted lines). Chart 10No Fundamental Changes From CSPP As can be seen in the chart, there is no material difference in any of the ratios for bonds within or outside the CSPP. The one notable exception is short-term liquidity, where the ratios were much lower for names purchased by the ECB than for those that were not. This lends credence to the idea that the CSPP most helped firms that were more liquidity-constrained, likely smaller companies. The biggest change in any of the ratios has been in interest coverage, but that has been for both CSPP and non-CSPP issuers, suggesting a common factor outside of ECB buying - zero/negative ECB policy rates, ECB purchases of government bonds that helped reduce all European borrowing rates - has been the main driver of lowering interest costs. Looking ahead, the ECB is likely to stop the net new purchases of its CSPP program when it does the same for the full APP next month. All of which is occurring for the same reason - the euro area economy is deemed by the central bank to no longer need the support of large-scale asset purchases given a full employment labor market and gently rising inflation. As we discussed in our Special Report last week, the ECB has other options available to them if there is a reduction in euro area banks' capacity or willingness to lend, such as introducing a new Targeted Long-Term Refinancing Operation (TLTRO). Continuing with unconventional measures involving direct ECB involvement in financial markets, like buying corporate debt, is no longer necessary. Our euro area CHM suggests that there are no major problems with European corporate health that require a wider credit risk premium. We still have our reservations, however, about recommending significant euro area corporate bond exposure while the ECB is set to end its asset purchase program. New buyers will certainly come in to replace the lost demand from the elimination of CSPP purchases, but private investors will likely require higher yields and spreads than the central bank - especially if the current period of slowing euro area growth were to continue. Bottom Line: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days for European corporate debt for the current cycle are behind us, as the ECB will not treat its corporate bond purchases any different than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade and high-yield. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Evaluating The ECB's Options In December", dated November 6th 2018, available at gfis.bcareserach.com and fes.bcaresearch.com. 2 The ECB report on its CSPP program was published in the March 2018 edition of the ECB Economic Bulletin, which can be found here. https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201804.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Equities had a wild ride in October, ... : The S&P 500 has bounced smartly off of its October 29th lows, but the decline that preceded the bounce was unusually severe. ... that unsettled a lot of investors, and made us reconsider our constructive take on risk assets: To judge by the November 5th Barron's, and some client conversations, several technically-minded investors are unconvinced by the bounce. Nothing has changed with our equity downgrade checklist, however, ... : The fundamental picture hasn't changed at all - neither corporate revenues nor margins appear to be in any immediate difficulty; though we still expect inflation to surprise to the upside, the latest data will not push the Fed to speed up its gradual rate-hike pace; and the combination of blockbuster third-quarter earnings and October's selloff made valuations more reasonable. ... so we see no reason to downgrade equities now, though we do have the admonition of a Wall Street legend ringing in our ears: If the fundamental backdrop remained unchanged, we would be inclined to upgrade equities if the S&P 500 got back to the 2,600-2,640 range, even though we are operating with a heightened sense of vigilance befitting the lateness of the hour. Feature It has been just four weeks since we rolled out our equity downgrade checklist. We would not ordinarily devote an entire Weekly Report to reviewing all of its components, but the last four weeks have hardly been ordinary. The swiftness of the decline, and the apparent lateness of the cycle, have unsettled investors enough to make several of them reconsider just how long they want to stay at the bull-market party. At times when market action provokes emotional gut checks, it is essential for investors to have a process to fall back on. Process provides a rational, objective haven from noise and emotion, and should help foster better decision-making. Our commitment to process underpins our fondness for checklists. They will never be comprehensive - as usual, we have our minds on other important inputs - but they help to ground our thinking, and we're happy to have them when markets make wild swings. Has The Recession Timetable Speeded Up? We are not interested in recessions for their own sake - we'll let the NBER's Business Cycle Dating Committee tell us when recessions begin and end, several months after the fact - but they're poison for risk assets. Any asset allocator who can recognize them in a timely fashion has a leg up on outperforming the competition. We therefore have been repeatedly monitoring the individual components of our recession indicator (Table 1). They do not betray any more concern than they did four weeks ago. Table 1Equity Downgrade Checklist The yield curve is clearly flattening, just as one would expect as the Fed gets further into a rate-hiking campaign, but it is still a comfortable distance from inverting (Chart 1). We think yields at the long end have a way to go before they stop rising, so we expect the fed funds rate will have to get well into the 3's before the 3-month bill rate can overtake the 10-year Treasury yield. The Conference Board's Leading Economic Indicator is still expanding at a robust clip (Chart 2). Finally, we estimate the fed funds rate is about a year away from exceeding the equilibrium rate, thus signaling that policy has turned restrictive. Chart 1The Yield Curve Is Flattening, But It's Not About To Invert ... Chart 2... And Leading Economic Indicators Are Still Surging The unemployment rate continues to fall. Reversing the trend so that the three-month moving average could back up by the third of a percentage point that has unfailingly accompanied recessions (Chart 3) would require net monthly payroll additions to crater. Assuming annual population growth of 1%, and a constant labor force participation rate, net monthly job gains would have to fall to 100,000 for the three-month moving average to back up to 4% in 2020; if the pace of gains merely held at 120,000, the unemployment recession signal wouldn't be issued until 2021 (Chart 4). We applied the same conditions to the Atlanta Fed's online unemployment calculator to see what it would take for the unemployment rate to cross into the danger zone in 2019 (Table 2). Since the seven-year trend of 200,000 monthly net payroll additions would have to reverse on a dime for unemployment to issue a near-term warning, we do not foresee checking this box anytime soon. Chart 3Investors Should Beware An Uptick In The Unemployment Rate ... Chart 4... But None Is Forthcoming ... Table 2... Unless Hiring Falls Off A Cliff Are Corporate Earnings Coming Under Pressure? As we mentioned last week, we view the labor market as tight and getting tighter. We thereby expect that wages are on their way to rising enough to crimp corporate margins, albeit slowly. The composite employment cost index has been in an uptrend since 2016, but it ticked lower last month, and remains well below its cyclical highs ahead of the last two recessions (Chart 5). Chart 5Snails, Godot, Molasses And Wages October's global upheaval was good for the safe-haven dollar, which surged to a new year-to-date high (Chart 6). The DXY dollar index is now within 3% of the 100 level that would lead us to check the dollar strength box. Even though we're not checking the box yet, the dollar's 10% advance since mid-February will exert a modest drag on S&P 500 earnings for the next few quarters. Triple-B corporate yields have ticked a little higher since we rolled out the checklist, extending their six-year highs (Chart 7), though we still view them as manageable. Chart 6A Gentle Headwind (For Now) Chart 7Higher Yields Aren't Biting Yet A rising savings rate would cancel out some of the top-line benefits from employment gains. It fell pretty sharply in the third quarter, however, amplifying the self-reinforcing effect of new hiring. It's at the bottom of the range that's prevailed since 2014 (Chart 8), but could go still lower if consumption tracks the robust consumer confidence readings, as it consistently has in the past. Chart 8Consumers Are Well-Fortified EM economies have become considerably more indebted since the crisis, as developed-world savings sought an outlet; corporate profits are falling; and a stronger dollar makes it harder for EM borrowers to service their USD-denominated debt. A credit crisis (or multiple credit crises) could slow global activity enough to pressure multinationals' earnings, even if the U.S. economy is mostly insulated from EM wobbles. EM equities have gotten a respite since global equities put in their year-to-date lows, and Chinese stimulus could extend EM economies a lifeline, though BCA expects that Beijing will disappoint investors hoping for a meaningful boost. We remain bearish on emerging markets as a firm, but EM distress is not anywhere near acute enough to justify ticking the box. Is Inflation Starting To Make The Fed Uneasy? There are two channels by which inflation could pose a problem for equities. The first is the Fed: if it is discomfited by what it sees in realized inflation, or perceives that inflation expectations could become unanchored, it is likely to move forcefully to quash upward pressure on prices. A forceful pace is considerably faster than a gradual pace, and would bring forward a monetary policy inflection. If policy flips from accommodative to restrictive sooner than we expect, the window for risk-asset outperformance will shrink. With all of its talk about symmetric inflation targets, the FOMC has made it clear that it will not make any attempt to defend its 2% core PCE inflation target. It is comfortable with an overshoot, and has indeed openly wished for one for much of the post-crisis era. There are limits to its indulgence, however, and we suspect that the Fed would not be comfortable if core PCE inflation were to make a new 20-year high above 2.5%. With that red line far off (Chart 9), inflation is not yet likely to encourage the Fed to quicken the pace at which it removes accommodation. Chart 9Turtles, Sloths And Inflation Inflation expectations aren't yet pressing the Fed to speed things up, either. Long-maturity TIPS break-evens have retreated slightly since mid-October, and have yet to enter the range consistent with the 2% inflation target (Chart 10). The media and the broad mass of investors don't bother with symmetric targets, or implied break-evens; they take their cues from consumer prices. A multiple haircut driven by popular inflation fears is the second channel by which inflation could halt the equity advance, but CPI remains well below the mid-3% levels that would provoke concern (Chart 11). Chart 10Stubbornly Well-Anchored Chart 11No Reason To Trim Multiples Yet So What's To Worry About? Irrational exuberance is always a concern after an extended period of gains, but there's no sign of it in broad market measures right now. Blockbuster earnings gains have pulled the S&P 500's forward P/E multiple back down to the 15s from its January peak above 18. Secondary measures like price-to-sales, price-to-book, and price-to-cash-flow are well below extreme levels in the aggregate. If the S&P 500 is going to get silly, it will have to surge first. That said, the latter stages of bull markets and expansions can be perilous, and we are on high alert. We continue to actively seek out any evidence that challenges our broadly constructive take on risk assets and the U.S. economy. Though we have yet to find anything compelling, an admonition from legendary technical analyst and strategist Bob Farrell has lodged in our mind. Rule number nine of Farrell's ten market rules to remember states, "When all the experts and forecasts agree - something else is going to happen." It's much more fun to bring novel views and analysis to our clients, but we don't get overly concerned about agreeing with investor consensus. It's inevitable that a lot of people will agree in the middle of extended cycles; we simply strive to be among the first to recognize the major macro inflection points and determine the optimal asset-allocation framework to benefit from them. We get a little antsy, though, when everyone knows that something is either certain to happen, or cannot happen by any stretch of the imagination. The near-unanimity with which the investment community believes that a recession cannot begin in 2019 is increasingly eating at us. We have been checking and re-checking the data, and checking and re-checking our colleagues' various models, in search of trouble, but to no avail. Even though recessions begin at economic peaks, and the economy nearly always appears to be in fine fettle when the downturn asserts itself, the sizable fiscal thrust on tap for 2019 seems to obviate the possibility of a contraction. When discussing potential risks in face-to-face meetings with clients this week, we most often cited trade tensions, as any material rollback of globalization would erode corporate profit margins and would strike at global trade, on which much of the rest of world's economies rely. A dramatic worsening of the trade picture is not our base case, but we do expect upside surprises in inflation, and an attendant upside surprise in the terminal fed funds rate. We have been considering that view mainly from the perspective of fixed-income positioning: underweight Treasuries and maintain below-benchmark duration. We also have been assuming that the FOMC would lift the fed funds rate to 3.5% at the end of 2019 via four quarter-point rate hikes, and possibly take it all the way to 4% in the first half of 2020. If it were to speed up its pace, and take the fed funds rate to 3.5% by the middle of next year, and 4% by the end, we believe financial conditions would tighten enough to choke off the expansion. Monetary policy impacts the economy with a lag, so a recession may still not begin until 2020 in that scenario, but we'd bet that an equity bear market would begin in 2019. Investment Implications Balanced investors should maintain at least an equal weight position in equities. Although our checklist is a downgrade checklist, we're alert to opportunities to upgrade as well as downgrade. As we first wrote one week before the October selloff ended, we would look to overweight equities if the S&P 500 were to dip back into the 2,600-2,640 range (Chart 12). If U.S. equities wobble again in line with our Global Investment Strategy team's MacroQuant model's near-term discomfort, investors may get another opportunity before the year is out. Chart 12Only One Chance To Upgrade So Far, But There May Be More Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com
As is tradition, during client visits in Europe last week, I had the pleasure of reconnecting with Ms. Mea, a long-term BCA client.1 It was our third encounter and, as always, Ms. Mea was eager to delve into our reasoning, challenge our views and strategy, as well as gauge our conviction level. We devote this week's report to key parts of our dialogue. I hope clients find it insightful and beneficial. Ms. Mea: Isn't the EM selloff and underperformance already overextended? I am afraid you will overstay your negative view on EM risk assets as happened in 2016. What are you watching to ensure you alter your stance as and when appropriate? Answer: I am very cognizant of not overstaying my negative stance on EM. I viewed the EM/China rally from their 2016 lows as a mid-cycle outperformance in a structural downtrend.2 Consequently, I argued the rally was not sustainable and that it was a matter of time before EMs and China-plays entered into a new bear market. Barring perfect timing, it was difficult to make money during that rally. Investors who averaged in EM stocks and local bonds over the past three years (including late 2015/early 2016 lows) and did not sell early this year have not made money. The current down-leg in EM financial markets may be the last phase of the bear market/underperformance that began in 2011, and it will eventually create a major buying opportunity. That said, this bear market will likely last much longer and be larger in magnitude than many investors expect. In the recent report titled EMs Are In A Bear Market, I elaborated on why this is a bear market and not just a correction. We also discussed how much further it might go.3 Big-picture macro themes - such as China/EM credit excesses and misallocation of capital - have informed my core views in recent years. Notwithstanding, I am watching various market signals that often lead economic data and are typically early in signaling a reversal in financial markets. Just a few examples of market signals and indicators I am following closely: Turns in EM corporate bond yields often coincide with reversals in EM stocks. For now, EM corporate bond yields are rising, and hence they do not signal a bottom in EM share prices (Chart I-1, top panel). Chart I-1EM/Asian Corporate Bonds Signal Downside Risks To Share Prices The same holds true for Emerging Asian markets: surging corporate bond yields are heralding further declines in Asian share prices (Chart I-1, bottom panel). Our Risk-on versus Safe-Haven (RSH) currency ratio positively correlates with EM equity prices. The RSH ratio has recently rebounded but has not broken above its 200-day moving average (Chart I-2). Hence, there is no meaningful buy signal as of yet. Chart I-2Our Market Risk Indicator The annual rate of change of this indicator leads the global trade cycles and entails further slowdown in global trade (Chart I-3). Chart I-3Global Trade Slowdown Is Not Over Finally, a number of EM equity indexes - small-caps and an equal-weighted index - have broken below their 3-year moving averages (Chart I-4). This entails that the selloff in EM stocks is very broad-based. It could also entail that the overall EM index will likely break below its 3-year moving average as well (Chart I-4, bottom panel). Chart I-4EM Equity Selloff Has Been Broad-Based Apart from market signals, I am also monitoring economic data, and so far, there are few signs of a revival in global trade or EM growth. The EM manufacturing PMI is falling (Chart I-5, top panel). Manufacturing output growth in Asia and Germany are decelerating sharply (Chart I-5, bottom panel). When global trade growth underwhelms, EM risk assets and currencies fare poorly. Chart I-5Global Growth And EM Credit Spreads Remarkably, both panels of Chart I-5 corroborate that the key reason for the EM selloff this year has not been the Federal Reserve tightening but the deceleration in global trade. We do not foresee a reversal in global trade and China/EM growth deceleration in the coming months. This heralds maintaining our negative view on EM risk assets and currencies for now. Ms. Mea: It is true that China is slowing, but policymakers are also stimulating and a lot of bad news may already be priced into China-related markets. Why do you believe there is more downside in China-related markets and EM risk assets from today's levels? Answer: Indeed, China is easing policy, but policy stimulus has so far been limited. It also works with a time lag. First, the bottoms in the money and the combined credit and fiscal spending impulses preceded the trough in EM and commodities by 6 months at the bottom in 2015 and by about 15 months at the top in 2017 (Chart I-6). Even if the money as well as credit and fiscal impulses bottom today it could take several more months before the selloff in EM financial markets and commodities prices abates. Chart I-6China: Money, Credit And Fiscal Impulses And Financial Markets Second, the stimulus has so far been limited. The recently increased issuance of special bonds by local governments was already part of this year's budget. Simply, it was delayed early this year and has been pushed into the third quarter. In addition, there are reports that 42% of this recent special bond issuance will be used for rural land purchases rather than infrastructure spending.4 The former will not boost economic activity and demand for raw materials and industrial goods. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report5 that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend and borrowers' readiness to borrow) and the velocity of money (marginal propensity to spend among households and companies). On both accounts, odds are that the transmission mechanism will be slower and somewhat impaired this time around than in the past. Chart I-7 illustrates that the marginal propensity to spend/invest by companies is diminishing, and it has historically defined the primary trend in industrial metals prices. Chart I-7China: Companies Are Turning More Cautious On Capex Third, most of the fiscal stimulus - tax cuts and income tax deductions - are designed to raise household incomes. This will primarily help spending on some consumer goods and services. Yet, there will be little help for property sales, construction and infrastructure spending. These three types of spending drive most of the demand for commodities, materials and industrial goods. In turn, industrial goods, machinery, commodities and materials account for about 80% of total Chinese imports. Hence, the channels by which China affects the rest of the world are via imports of capital goods, materials and commodities. Overall, China's tax reforms will have little bearing on its imports from other countries. The latter are heavily exposed to the mainland's construction and infrastructure spending, which in turn are driven by the Chinese credit cycle. This is why we spend so much time analyzing mainland money and credit cycles. Finally, the significance of U.S. import tariffs for the Chinese economy should be put into perspective. China's exports to the U.S. make up only 3.6% of its GDP. This compares with the mainland's total exports of 20% and capital spending of 42% of GDP (Chart I-8). Chart I-8What Drives China's Growth Consequently, capital spending is much more important to the Middle Kingdom's growth than its shipments to the U.S. That said, the trade confrontation between the U.S. and China is likely already negatively affecting overall business and consumer confidence in China (Chart I-9). Chart I-9China: Service Sector Is Moderating In addition, Chart I-10 illustrates that China's manufacturing PMI for export orders have plunged, signifying an imminent slump in its exports. This could be due to its shipments not only to the U.S. but also to developing economies, which account for a larger share of total exports than shipments to the U.S. and EU combined. Considerable depreciation in EM currencies has made their imports more expensive, dampening their capacity to import. Chart I-10Chinese Exports Are At Risk In brief, China's growth will continue to disappoint, weighing on China plays in financial markets. Ms. Mea: Why has strong U.S. growth not helped global trade, China and EM in general? How do U.S. economic and financial markets enter into your analysis about the world and EM? Answer: One common mistake that many commentators make is to form a view on the U.S. growth outlook and then extrapolate it to the rest of the world. The U.S. economy is still the largest, but it is no longer the sole dominant force in the global economy. Chart I-11 shows that U.S. and EU annual imports are equal to $2.5 and $2.2 trillion, respectively. Combined annual imports of China and the rest of EM amount to $6 trillion - hence, they are much larger than the aggregate imports of U.S. and EU. This is why global trade can deviate from time to time from U.S. domestic demand cycles. Chart I-11EM Imports Are Larger Than U.S. And EU Imports Together That said, due to their sheer size, U.S. financial markets have a much larger impact on global markets than U.S. imports do on global trade. EM financial markets are greatly influenced by their counterparts in the U.S. In this respect, we have a few observations: U.S. growth is robust, the labor market is tight and core inflation is rising. Barring a major deflation shock from EM, the path of least resistance for U.S. bond yields and the fed funds rate is up. Continued rate hikes by the Fed constitute a major menace to EM risk assets. For now, the growth divergence between the U.S. and rest of the world will continue to be manifested in a stronger U.S. dollar. This is a bad omen for EMs. Chart I-12A Risk To U.S. Share Prices Rising U.S. corporate bond yields have historically been associated with lower U.S. share prices, and presently portend a further drop in American equities (Chart I-12). Finally, the surge in equity market leaders - specifically, new economy stocks - has been on par with previous bubbles, as shown in Chart I-13. Chart I-13History Of Financial Bubbles It is impossible to know whether or not this is a bubble that has already reached its top. But the magnitude and speed of the rally, at minimum, warrant a consolidation phase. On the whole, Fed tightening, rising corporate bond yields, a strong dollar and elevated valuations warrant further correction in U.S. share prices. This will reinforce the downtrend in EM risk assets. Ms. Mea: Are fundamentals in many EM countries not better today than they were amid the taper tantrum in 2013? Specifically, current account balances in many developing nations have improved and their currencies have cheapened. Answer: Your observation is correct - current account deficits have improved and currencies have become much cheaper than before. Nevertheless, these are necessary but not sufficient conditions to turn bullish: First, marginal shifts in balance of payments drive exchange rates. Even though current account deficits are currently smaller and currencies are moderately cheap in many EMs, a deterioration in their current accounts due to weakening exports in general and falling commodities prices in particular will depress their currencies. In this context, China's imports are critical. As they decelerate, EM ex-China's current account balances will deteriorate and their exchange rates will depreciate. Second, current account surpluses do not always preclude currency depreciation. Chart I-14 shows that the Korean won, the Taiwanese dollar and the Malaysian ringgit experienced bouts of depreciation, despite running current account surpluses. Chart I-14Current Account Surpluses And Exchange Rates Third, emerging Asian currencies are at a risk from another spell of RMB depreciation. Chart I-15 illustrates that CNY/USD exchange rate correlates with the interest rate differential between China and the U.S. As the Fed hikes rates further and the People's Bank of China (PBoC) keep interest rates stable, the yuan will likely depreciate against the greenback. Chart I-15CNY/USD And Interest Rates Despite capital controls, it seems the interest rate differential affects the exchange rate in China too. Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. If the authorities push up interest rates to make the yuan attractive to hold, it will hurt the already overleveraged and weak economy. If the PBoC reduces interest rates further to help the real economy, the RMB will come under depreciation pressure. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-worst outcome for the nation. Yet, this will rattle Asian currencies and risk assets. Finally, EM currency valuations are but particularly cheap, except Argentina, Turkey and Mexico as depicted in Chart I-16A & Chart I-16B. When currency valuations are not at an extreme, they usually do not matter for the medium-term outlook. Chart I-16AEM Currency Valuations Chart I-16BEM Currency Valuations As to the EM fixed-income market, exchange rates are the key driver of their performance. Currencies depreciation causes a selloff in high-yielding local currency bonds and typically leads to credit spread widening. The latter occurs because U.S. dollar debt becomes more difficult to service when the value of local currency declines. Besides, EM currencies usually weaken amid a global trade slowdown and falling commodities prices. The latter two undermine issuers' revenues and their capacity to service debt, warranting wider credit spreads. Ms. Mea: What about equity valuations? Aren't they cheap? Chart I-17EM Equity Multiples Answer: EM stocks are not very cheap. Our composite valuation indicator based on a 20% trimmed mean of trailing and forward P/Es, PBV, price-to-cash earnings and price-to-dividend ratios denotes a slightly attractive valuation (Chart I-17). According to our cyclically-adjusted P/E ratio, EM equities are also moderately cheap (Chart I-18). Chart I-18EM Equities: Cyclically-Adjusted P/E Ratio In short, EM equity valuations are modestly cheap. As with currencies, however, unless valuations are at an extreme (say, one or two-standard deviations from their mean), they may not matter for a while. Barring extreme over- or undervaluation, share prices are typically driven by profit cycles. Importantly, EM corporate earnings are set to decelerate further and probably contract in the first half of 2019 (Chart I-19). If this scenario transpires, share prices will drop further, regardless of valuations. Chart I-19EM Corporate Earnings Are At Risk Ms. Mea: Why don't you write about risks to your view? And, I would like to use this opportunity to ask what are the risks to your view presently? Answer: The basis of why I do not write about the risks to my view is as follows: The risks to a view are often the cases when the key pillars of analysis do not play out. It follows that in these cases, the risks to the view are obvious and there is no need to write about them. To sum up our discussion today, the key pillars of my view are: China's policy stimulus has so far been moderate and the stimulus usually works with a time lag. Additionally, the combination of the regulatory tightening on banks and non-bank financial organizations and the lingering credit and property market excesses in China will generate a growth slowdown that will be longer and deeper than the markets currently expect. The Fed will continue ratcheting up rates as U.S. core inflation is grinding higher. The combination of the above three will produce weaker global growth, a stronger U.S. dollar, and lower commodities prices. All in all, these are bearish for EM risk assets. It is evident that if these themes and assumptions are incorrect, the view will be wrong. Hence, writing that the risks to my view are that my assumptions and themes are mistaken is nothing other than tautology. That said, there are seldom cases when the underlying economic themes and the assumptions are valid, yet the investment recommendations are amiss. These are, in fact, true risks to the view and they are worthy of discussion. Yet, identifying in advance what could go wrong when the analysis and assumption are accurate is very difficult. Presently, I can think of one reason why my investment recommendations could be erroneous even if my economic themes end up being largely valid: It is the shortage of investable assets worldwide relative to capital that is looking to be invested. Quantitative easing programs in the advanced economies have shrunk the size of investable assets. As a result, too much money is chasing too few assets. Consequently, the risk to my view is that EM assets never become sufficiently cheap and that fundamentals do not matter that much. In other words, investors could rush back into EM risk assets despite the poor growth backdrop and not-so-cheap valuations. This is akin to a game of musical chairs where the number of participants is greater than the number of chairs. To complicate things, some chairs are broken, i.e., some assets are of bad quality. As a result, game participants (i.e., investors) are now facing a tough choice between (1) being somewhat prudent and risking being left without a chair; or (2) rushing in and getting either a good chair or a broken chair (depending on luck). Applying this musical chairs analogy, buying EM risk assets at the current juncture is similar to rushing in and hoping to get a good chair. It is a very high-risk bet and success is contingent on luck. In my subjective assessment, there is about a 30% chance that this strategy - buying EM risk now - will be successful with 70% odds favoring being risk averse for the time being. The latter entails staying with a defensive strategy in EM and underweighting/shorting EM versus DM. Ms. Mea: What is your recommended country allocation currently? Answer: In the EM equity space, our overweights are Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia, and central Europe. Our underweights, on the other hand, are India, Indonesia, the Philippines, Hong Kong, South Africa and Peru. Chart I-20 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-20EMS's Fully-Invested Model Equity Portfolio Performance This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. In the currency space, we continue recommending shorting a basket of the following EM currencies versus the dollar: ZAR, IDR, MYR, KRW and CLP. The full list of our country recommendations for equity, local fixed-income, credit and currency markets are available below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Reports, "Where Are EMs In The Cycle?" dated May 3, 2018 and "Ms. Mea Challenges The EMS View," dated October 19, 2018, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018, available at ems.bcaresearch.com. 4 Please see: https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 5 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 25, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Chart 12015 Repeat? Credit spreads widened as Treasury yields rose in October, bringing to mind the experience of 2015 when tight monetary policy and flagging global growth combined to cause a large drawdown in spread product excess returns. Chart 1 shows the familiar pattern. The market's rate hike expectations held constant throughout most of 2015. Meanwhile, falling commodity prices signaled weakness in global demand. Eventually, the combination of tight money and slowing growth was too much for the market to bear. Junk sold off in late-2015 and didn't recover until after the Fed scaled back its rate hike plans. It's hard to ignore today's similar set-up. Commodity prices are once again falling and the Fed appears committed to lifting rates. Unless global demand rebounds, we could be in for a repeat of late-2015's ugly price performance. The best way to position U.S. bond portfolios for this risk is to maintain below-benchmark portfolio duration, and to scale back exposure to credit risk. We advocate nothing more than a neutral allocation to spread product, with an up-in-quality bias. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 82 basis points in October, dragging year-to-date excess returns down to -98 bps. The index option-adjusted spread widened 12 bps on the month, and currently sits at 117 bps. Recent spread widening has returned some value to the corporate bond space. The 12-month breakeven spread for Baa-rated corporate bonds is back up to its 36th percentile relative to history, while the same spread for A-rated securities is at its 18th percentile (Chart 2). Chart 2Investment Grade Market Overview Though spreads are somewhat more attractive, caution remains warranted in the corporate bond space. Corporate profit growth has only just managed to keep pace with debt growth during the past few quarters (bottom panel). In other words, even a mild deceleration in profits will be enough for leverage to resume its uptrend (panel 4). As we observed in last week's report, Q3's sharp decline in non-residential investment spending might signal that weak foreign growth is finally starting to weigh on profits.1 The possibility of rising leverage in the coming quarters leads us to recommend an up-in-quality bias within our neutral allocation to corporate bonds. To pick up extra spread we prefer a strategy of favoring long-maturity credits over short maturities. In last week's report we showed that the long-end of the credit curve outperforms (in excess return terms) when Treasury yields rise. High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 159 basis points in October, dragging year-to-date excess returns down to +161 bps. The average index option-adjusted spread widened 55 bps on the month, and currently sits at 363 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 259 bps, above the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months and junk spreads remain constant, we should expect high-yield returns of 259 bps in excess of duration-matched Treasuries. If we assume that spreads tighten enough to bring our default-adjusted spread back to its long-run average, we would expect an excess return of 306 bps. Chart 3High-Yield Market Overview The main reason for continued caution on junk bonds is that the default loss expectation embedded in our excess spread calculation is extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.04% during the next 12 months. Default losses have rarely come in below that level. Further, the recent trend in job cut announcements makes it even more likely that default losses surprise to the upside during the next 12 months. Job cut announcements are highly correlated with the default rate, and while they remain low relative to history, they have clearly formed a trough this year (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in October, dragging year-to-date excess returns down to -44 bps. The conventional 30-year zero-volatility MBS spread increased 2 bps on the month. A 4 bps widening of the option-adjusted spread (OAS) was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). The OAS has widened in recent months, though it remains tight compared to its average pre-crisis level (Chart 4). The overall nominal MBS spread remains very low, but for good reason (panel 4). Chart 4MBS Market Overview The two most important drivers of MBS excess returns are: (i) mortgage refinancing activity and (ii) bank lending standards. Refi activity is already depressed and will stay muted as interest rates rise. Bank lending standards eased in Q2 for the 17th consecutive quarter, but remain tight relative to history. In response to a special question from the Fed's July Senior Loan Officer Survey, respondents noted that mortgage lending standards are in the tighter end of the range since 2005. This suggests that further gradual easing is likely going forward. With lending standards easing and refi activity low, the macro environment is consistent with tight MBS spreads. We maintain only a neutral allocation to the sector for now, but will look to upgrade when it comes time to further pare exposure to corporate credit risk. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 55 basis points in October, dragging year-to-date excess returns down to -16 bps. Sovereign debt underperformed the Treasury benchmark by 184 bps, dragging year-to-date excess returns down to -118 bps. Foreign Agencies underperformed by 94 bps on the month, dragging year-to-date excess returns down to -60 bps. Local Authorities underperformed by 28 bps, dragging year-to-date excess returns down to +63 bps. Supranationals underperformed Treasuries by 3 bps, dragging year-to-date excess returns down to +13 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +5 bps. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.2 Those countries being Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. Not only does the sector offer elevated spreads (Chart 5), but it is dominated by taxable municipal securities which are insulated from weak foreign growth and U.S. dollar strength. Chart 5Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 1% in October, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview But despite the low yield ratio, we see tax-exempt municipal yields as quite attractive, especially at the long-end of the curve. For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.55% versus a yield of 3.62% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. Further, unlike the corporate sector, state & local government balance sheets are relatively insulated from weakening foreign economic growth and a rising U.S. dollar. While our Municipal Health Monitor has bounced in recent quarters, it remains below zero, consistent with ratings upgrades outpacing downgrades (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell The Treasury curve bear-steepened in October. The 2/10 slope steepened 4 bps and the 5/30 slope steepened 16 bps. As a result of the large curve steepening, our position long the 7-year bullet and short the 1/20 barbell returned +67 bps on the month, and is now up +107 bps since inception. However, the curve steepening also means that steepener trades focused on the belly (5-7 year) of the curve are no longer attractive according to our models (see Tables 4 & 5). The 7-year bullet is now fairly valued relative to the 1/20 barbell, meaning that the butterfly spread is priced for an unchanged 1/20 slope during the next six months (Chart 7). Our baseline macro assessment is that the yield curve slope will remain near current levels during that timeframe. As such, we close our position long the 7-year bullet and short the 1/20 barbell. Chart 7Treasury Yield Curve Overview Absent attractive value, the only reason to focus curve exposure on the 5-7 year maturity point is as a hedge against an unexpected pause in Fed rate hikes. In prior research we showed that the belly of the curve performs best when the 12-month discounter falls.3 But with our discounter priced for only 61 bps of rate hikes for the next 12 months, this risk may not be worth hedging. Instead, we prefer to go long the 2-year bullet and short a duration-matched 1/5 barbell. This trade is attractively priced on our model (bottom panel) and should outperform in a rising yield environment. The 1/5 slope tends to steepen when our 12-month discounter rises, and vice-versa. TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 61 basis points in October, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 9 bps on the month and currently sits at 2.06%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 9 bps on the month and currently sits at 2.21%. Both the 10-year and the 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We think it is only a matter of time before inflation expectations adjust higher into that range, and we therefore maintain an overweight position in TIPS versus nominal Treasuries. The catalyst for wider TIPS breakevens will be persistent inflation readings near the Fed's 2% target. Trimmed mean inflation has only just returned to the Fed's 2% target (Chart 8), but will probably remain close to that level for the next six months. While base effects will pose a higher hurdle for year-over-year inflation during this time, pipeline inflation pressures are also building, as evidenced by the prices paid component of the ISM Manufacturing survey (panel 4).4 Chart 8Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month and now stands at 38 bps, 4 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to both Supranationals and Domestic Agencies, but carry a substantially higher risk of losses. Agency CMBS appear much more attractive than consumer ABS on a risk/reward basis, offering approximately the same expected return with less risk. From a credit quality perspective, the consumer credit delinquency rate remains low by historical standards but has clearly put in a bottom (Chart 9). The household interest coverage ratio has been rising for 10 consecutive quarters, suggesting that the delinquency rate will continue to increase. Chart 9ABS Market Overview We remain neutral on consumer ABS for now, but prefer Local Authorities, Municipal Bonds and Agency-backed CMBS when it comes to high-quality spread product. If consumer credit delinquencies continue to rise without a commensurate increase in ABS spreads, then our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +120 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 10 bps on the month and currently sits at 94 bps (Chart 10). Chart 10CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed's Q2 Senior Loan Officer Survey showed that both lending standards and demand are close to unchanged. In other words, the macro picture for CMBS is decidedly mixed. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 51 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 2, 2018) Chart 12Total Return Bond Map (As Of November 2, 2018) Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk", dated October 9, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 4 For details on our base effects indicator for PCE inflation, please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1
Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Chart 11Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Dear Client, You will see in this Monthly Portfolio Update that we have expanded our table of Recommendations to include a wider range of the views that Global Asset Allocation (GAA) regularly discusses in its publications. Please see our most recent Quarterly Portfolio Outlook1 for a detailed explanation of those recommendations that we do not specifically touch on in this Monthly. A note on our publication schedule. We will not publish a Monthly for December, or a Q1 2019 Quarterly in mid-December. Instead, we will send you in late November the BCA 2019 Outlook (BCA's annual discussion with Mr. and Ms. X). This will be accompanied by a short GAA note, updating our recommendation tables with a brief commentary. Best Regards, Garry Evans A Correction, Not A Bear Market Investors have a tendency to forget that corrections are common in bull markets. The current equity run-up, which began in March 2009, has seen five corrections (defined as a 10-20% decline in the S&P500). We may now be experiencing the sixth, with the index already down 9.9% from its peak on September 20. Recommendations But we think the evidence is fairly strong that this is just a correction and not the beginning of a new bear market (using the common definition of a 20% or greater fall). It is highly unusual for bear markets to occur - and for bonds to outperform equities - except in the run-up to, and during, recessions (Chart 1). We see little to suggest that a recession in on the horizon over the next 12 months. Chart 1Corrections Are Not At All Rare What caused the correction? The immediate trigger was a seemingly concerted series of statements in early October from FOMC officials, including even doves such as Lael Brainard, that economic circumstances are "remarkably positive" and that rates remain "a long way from neutral" (to quote Fed Chair Jay Powell). In particular, New York Fed President John Williams argued that the neutral rate of interest (the r*) is very uncertain - even though he was joint creator of the main model that estimates it. The implication is that the Fed will keep on raising rates until the economy clearly slows. This pushed the 10-year Treasury yield above 3.2%. Markets are starting to worry that the Fed will make a policy mistake and that certain segments of the economy (housing, emerging markets?) may be too weak to withstand tighter monetary policy. Moreover, this is in a context in which global growth has been weakening (Chart 2), China appears to be slowing quite sharply (Chart 3), the trade war is escalating (with the U.S. now threatening to impose tariffs on all Chinese imports), and valuations for most assets are stretched. Chart 2Outside The U.S., Growth Is Slowing Chart 3Sharp Slowdown Ahead For China? So how worried should investors be? Most of the usual indicators of generalized risk aversion have not flashed strong warning signals during the equity market sell-off (Chart 4). The move up in bond yields came mostly from a rise in real yields, not inflation expectations, and the yield curve steepened, suggesting that markets are pricing in stronger growth not excessive Fed action. Safe haven assets, such as gold and the Swiss franc, did not perform particularly strongly. Credit spreads rose a little, by around 70 basis points, but do not yet signal stress. Chart 4No Signals Of Strong Risk Aversion Moreover U.S. growth, in particular, remains robust. Though the r* may be tricky to estimate, monetary policy is still clearly accommodative and is likely to remain so until at least mid-2019, even if the Fed hikes by 25bp a quarter (Chart 5). Fiscal policy will be stimulative until the end of 2019, adding 1.1 percentage points to growth this year and 0.5 next, according to IMF estimates. Earnings growth will slow from its current lick - Q3 U.S. earnings look like coming in at 23% year-on-year, compared to a forecast of 19% before the results season - but our models suggest that 2019 bottom-up estimates are about right, with growth slowing to around 10% in the U.S. and to somewhat less in the euro area and Japan (Chart 6).2 Chart 5Fed Policy Still Accomodative Chart 6Earnings Growth To Continue, Albeit More Slowly If we have a concern, it is that a few interest-rate sensitive elements of the U.S. economy are showing signs of softness. Housing starts have been weak for a while, but higher mortgage rates may now be having an effect, with residential investment subtracting from GDP growth in all three quarters so far this year (Chart 7). However, mortgage rates are unlikely to continue to rise at the same pace and so the effect should weaken in further quarters. Capex intentions and durable orders have also slipped, perhaps suggesting that corporations have reined back investment plans due to global uncertainties (Chart 8). But these signs point to slower growth next year, not recession, with the U.S. likely to continue to grow above trend. Historically, higher long-term rates have proved a drag on the economy only when they have risen above trend nominal GDP growth, currently around 3.8% (Chart 9). We have some way to go before we reach that tipping-point. Chart 7Housing Is Hurting Chart 8...And Capex Is Getting Cautious Chart 9Rates Matter When They Exceed Nominal Growth We moved to neutral on risk assets, including equities, at the beginning of July. Many of the worries we flagged then have come about. This is late in the cycle, and so volatility will probably remain elevated. However, we do not expect the next recession to come until 2020 at the earliest. Moreover, none of the warning signals on our bear market checklist (which includes the shape of the yield curve, profit margins, a peak in cyclical spending as a percentage of GDP, Fed policy becoming restrictive etc.) are yet flashing, though several may do by mid next year. Equity market valuations are no longer expensive after the recent sell-off (Chart 10). If the current correction were to continue and the drop in the S&P 500 extend to 15% and in global equities to 20% from their most recent peaks, we might be inclined tactically to move back overweight on risk assets. Chart 10Stocks Are No Longer Expensive Currencies: We expect further U.S. dollar appreciation. Divergences in growth and monetary policy between the U.S. and other developed markets will continue. While we expect the Fed to continue to hike once a quarter until end-2019, we could imagine the ECB turning more dovish if euro zone growth continues to slow and Italian BTP 10-year bond yields rise above 4%. The Bank of Japan will stick to its Yield Curve Control policy, which will prevent the yen rising. Emerging market currencies look vulnerable as their economies slow as a result of central bank rate hikes earlier in the year. Asian currencies might undertake competitive devaluations if the renminbi falls below 7, as a result of a worsening trade war. Fixed Income: Long-term rates are unlikely to have peaked for this cycle. Core inflation will stay at around 2% for a few more months because of a favorable base effect, but underlying inflation pressures (the result of rising wages and increases in import tariffs) will push up U.S. inflation by mid next year (Chart 11). A combination of higher inflation, steady Fed hikes, and deteriorating supply/demand conditions (which will raise the term premium) will move 10-year rates above 3.5% by mid-2019 (Chart 12). We accordingly recommend being short duration and overweight TIPs. U.S. high-yield bonds look somewhat attractive, with a default-adjusted spread of 270 bps, after their recent modest sell-off (Chart 13). But this is dependent on our assumption (based on Moody's model) of credit defaults of only 1.04% over the next 12 months.3 Given where we are in the cycle, and considering the elevated corporate leverage in the U.S., we do not consider this a risk worth taking, and so maintain our moderate underweight in credit. Chart 11Underlying Inflation Pressures Are Strong Chart 12Indicators Point To Treasury Yields Above 3.5% Chart 13Are Junk Bonds Attractive Again? Equities: We prefer DM equities over EM, and favor the U.S. and, to a degree, Japan. Emerging markets continue their deleveraging process and will be hurt by rising U.S. rates, a stronger dollar, and slowdown in China. Valuations for EM equities, though one standard deviation cheap relative to global equities, are not yet sufficiently attractively valued to permit investors to buy EM stocks irrespective of their poor fundamentals. Moreover, analysts are still far too optimistic on the outlook for EM earnings, flattering the valuation metric (Chart 14). Stronger growth and an appreciating currency point to an overweight in U.S. equities which, moreover, would be likely to outperform in the event of a deeper correction, given their low beta. Chart 14EM Equities Aren't As Cheap As They Seem Commodities: The crude oil price has fallen back a little in recent weeks, as a result of increases in OPEC production, a modest slowing of demand, and releases of the U.S. Strategic Petroleum Reserve. Our energy strategists have slightly lowered their 2019 Brent forecast to $92 a barrel, from $95 (Chart 15). However, they warn that geopolitical risks, such as widespread application of sanctions on Iran and a collapse in Venezuela, and limits to capacity in Saudi Arabia and U.S. shale production could easily cause spikes above $100.4 A 100% year-on-year rise in oil prices has historically been a clear warning of recession. That would equal Brent at $120 in 1H 2019. Metal prices will continue to be driven by China. At the moment we see no sign of China implementing a major stimulus, which would boost infrastructure spending and therefore demand for commodities (Chart 16), and so we expect further falls in industrial commodities prices. Chart 15Oil Prices Can Rise Further Chart 16No Sings Of Big China Stimilus Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see GAA Quarterly Portfolio Outlook - October 2018, available at gaa.bcaresearch.com 2 For details of these models and the assumptions behind them, please see The Bank Credit Analyst November 2018, available at bca.bcaresearch.com 3 For details please see BCA U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For details please see BCA Commodity & Energy Strategy & Bond Strategy Weekly Report, "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity", dated October 25, 2018, available at ces.bcaresearch.com GAA Asset Allocation