Inflation/Deflation

Highlights Global Growth: Early leading indicators (credit impulses, our global LEI diffusion index) are signaling that the worst of the global economic downturn should soon end. Okun’s Law: In the developed economies, the observed relationships between economic growth and changes in unemployment suggest that the current pullback in global growth will not be severe enough to create slack in labor markets and reduce inflation pressures. Global Bond Allocation: Within dedicated global government bond portfolios, stay underweight the U.S. and Canada, neutral core Europe, and overweight the U.K., Japan and Australia. Remain tactically overweight global credit versus government bonds, at least until mid-year, with policymakers likely to stay cautiously dovish until global uncertainties recede. Feature Is This Risk Rally Too Good To Last? The mood of financial markets has improved significantly over the past few weeks, led by the dovish shift from central bankers that has revived investor risk appetite. Some positive headlines on U.S.-China trade negotiations have also generated hope over prospects for a deal, further fueling the bullish sentiment. The global economic picture remains muddled, though. Non-U.S. growth continues to languish, while the actual near-term state of the U.S. economy is proving difficult to determine given the data issues surrounding the 35-day U.S. government shutdown. Given lingering uncertainties, both political and economic, policymakers do not want to rock the boat by saying anything that might be interpreted as hawkish. With monetary policy no longer a near-term headwind, there is a window for continued outperformance of global risk assets in the next few months. That means higher global equity prices and stable-to-tighter global corporate credit spreads. Yet the seeds for the next wave of market turbulence may already be sewn. There are signs that the global growth downturn may soon end. Credit impulses are starting to pick up in several major economies, while our diffusion index of global leading economic indicators – itself a longer leading indicator – has clearly bottomed (Chart of the Week). The epicenter of global economic weakness, China, continues to deploy monetary and fiscal stimulus measures aimed at stabilizing growth. Meanwhile, the U.S. economy still appears to be in good shape, underpinned by solid consumer fundamentals. Chart of the WeekSunnier Days Ahead? Sunnier Days Ahead? Sunnier Days Ahead? A combination of easier financial conditions and faster economic growth will eventually prove to be incompatible with stable monetary policy, especially with surprisingly firm inflation in the major developed economies. Central bankers will respond by moving away from their current dovish bias, led by the U.S. Federal Reserve. With government bond markets now discounting both stable monetary policy and too-low inflation expectations, the path for global bond yields is eventually higher. While headline inflation rates are cooling in response to the lagged impact of weaker oil prices, the pullback has been far more muted so far compared to similar sharp oil-driven moves in the past (Chart 2). This is because domestically-driven inflation rates for services and wages are much sturdier today in many countries. If BCA’s bullish oil view for 2019 comes to fruition, then the current decline in headline/goods inflation rates may prove to be very short-lived and with little pass-through into core/services inflation. Chart 2Sticky Global Inflation, Despite Lower Oil Prices Sticky Global Inflation, Despite Lower Oil Prices Sticky Global Inflation, Despite Lower Oil Prices This dynamic is not the same in every country, however. When looking at the individual trends of goods inflation and services/wage inflation in the major developed economies, the largest gaps between the two exist in the U.S. and Canada (Chart 3). There, wage growth is accelerating and services inflation rates remain sturdy, despite sharp drops in goods inflation. Chart 3Domestic Inflation Pressures Most Acute In The U.S. & Canada Domestic Inflation Pressures Most Acute In The U.S. & Canada Domestic Inflation Pressures Most Acute In The U.S. & Canada Our recommended government bond allocation at the country level reflects these underlying inflation trends. We are more bearish on bond markets with the most intense domestic inflation pressures – and where future interest rate hikes are most likely – and vice versa. We remain underweight the U.S. and Canada, where wage growth and services inflation are both above the inflation targets of the Fed and Bank of Canada, and where market-based measures of inflation expectations like CPI swap rates have already bottomed (Chart 4). We remain neutral on core Europe (Germany, France) where wage growth has perked up, core/services inflation remains closer to 1% than the 2% target of the ECB, and inflation expectations continue to drift lower. Finally, we remain overweight the U.K., Japan and Australia, all of which have an underlying inflation picture that is muted enough to keep policymakers on hold for at least the next 6-9 months. Chart 4Favor Bond Markets Where Domestic Inflation Pressures Are Weakest Favor Bond Markets Where Domestic Inflation Pressures Are Weakest Favor Bond Markets Where Domestic Inflation Pressures Are Weakest Bottom Line: Early leading indicators (credit impulses, our global LEI diffusion index) are signaling that the worst of the global economic downturn should soon end. Central bankers will remain cautious and dovish in the near-term, however, implying that the current outperformance of global equity and credit markets has more room to run – but also setting up the next upleg for bond yields later this year. Okun’s Law Revisited Central bankers remain wedded to the idea that there is an “exploitable” relationship between unemployment and inflation, a.k.a. the Phillips Curve. A logical extension is that unless policymakers can credibly forecast a reduction in labor demand that pushes unemployment rates beyond levels associated with full employment, inflation will not be expected to decline. Policymakers will have a difficult time staying dovish without believing that inflation pressures are diminishing. One way to measure the relationship between economic growth and changes in economic slack is by using a concept that you may remember from an old macroeconomics class – Okun’s Law. More an empirically observable rule of thumb than any rule based in actual economic theory, Okun’s Law simply measures how much unemployment rates change relative to swings in real GDP growth. Past estimations for the U.S. economy have shown that the long-run coefficient in the Okun’s Law regression is around 2, which means that a 2% fall in real GDP growth should be associated with a 1% increase in the unemployment rate (and vice versa). That coefficient is not the same over shorter time horizons, though, as the unemployment/GDP growth relationship can be impacted by other cyclical factors like changes in hours worked or labor productivity. Charts 5 and 6 show annual real GDP growth (the percentage change over four quarters) versus the change in the unemployment rate over twelve months for the major developed economies (the U.S., U.K., euro area, Japan, Canada, Australia, New Zealand and Sweden) dating back to 1980. There is a reasonably strong relationship between the two series in the charts, although the “fit” does vary from country to country. Chart 5The Okun’s Law Relationship … The Okun's Law Relationship... The Okun's Law Relationship... Chart 6… Still Holds For Most Countries ...Still Holds For Most Countries ...Still Holds For Most Countries That can be seen in the individual country scatterplots shown in Charts 7 to 14, which plot each quarterly data point of the change in unemployment and real GDP growth. The darker dots represent the period from 1980-2010, while the lighter dots are the post-2010 era. The actual estimated regression, and its R-squared, are also shown in the charts (the equation can be defined as “the estimated change in the unemployment rate for a given pace of real GDP growth”). Chart 7 Chart 8 Chart 9 Chart 10 Chart 11 Chart 12 Chart 13 Chart 14 For most countries shown, the R-squareds are reasonably good (between 0.55 and 0.70) for a single-factor model like this. The coefficients on the change in real GDP are all between -0.35 and -0.45, which means that a fall in real GDP growth of 3.5 to 4.5 percentage points is consistent with a rise in the unemployment rate of 1 percentage point. The lone country where the Okun’s Law relationship has a relatively poor historical fit is in Japan, which is due to the lack of GDP variability relative to swings in the unemployment rate, especially over the past decade. We can use these estimates of the Okun’s Law coefficient to conduct a “back of the envelope” thought experiment that answers the following question that relates to the current economic and financial market backdrop: how much of a decline in GDP growth is necessary to raise unemployment rates back to full-employment (NAIRU) levels? As we have consistently noted in recent Weekly Reports, global central bankers can only turn so dovish, even after the severe market turbulence seen at the end of last year and with elevated political uncertainty in many locations. Why? Because unemployment rates remain below levels that are consistent with stable inflation. Without a meaningful weakening of labor markets that pushes unemployment rates back above “full employment” levels, policymakers will not be able to lower their inflation forecasts and signal a need for easier monetary policy. In Table 1, we present the estimated Okun’s Law regressions from 1980, along with the real GDP growth rate that falls out of those equations if we assume the employment gaps are closed.1 We also show the consensus 2019 real GDP growth forecasts taken from Bloomberg, as well as the expected change in central bank policy rates over the next year taken from our Central Bank Discounters. The conclusion from the Table is that it would take significant declines in real GDP growth to raise unemployment rates enough for policymakers to become less worried about inflation pressures. Table 12019 Consensus Growth Forecasts Are Well Above Levels That Would Eliminate The Unemployment Gap Hope Springs Eternal Hope Springs Eternal In the U.K., where the unemployment rate is furthest below the OECD’s estimate of the full-employment NAIRU rate, a whopping -3.3 percentage point cut to real GDP growth is needed to raise unemployment back to 5.6%. The required GDP fall is lower in the U.S., with only a -1.6 percentage point decline in real GDP growth need to push the unemployment rate back to the OECD NAIRU estimate of 4.3%. Falls in real GDP growth of between -1.5 and 2.0 percentage points are necessary in most of the other countries to close the “unemployment gap”, except for Japan. Given the weak estimated Okun’s Law relationship in Japan, we are reluctant to put much weight on the results of this thought experiment for Japan. Those “required” declines in real GDP growth are nowhere close to the 2019 consensus Bloomberg forecasts for each country. This is even true in the U.S., where the consensus expects real GDP growth to decline by -0.9 percentage points in 2019. Unsurprisingly, markets are discounting very little change in monetary policy over the next year according to our Central Bank Discounters, with modest odds of a rate cut now discounted in Australia (-19bps), New Zealand (-11bps) and the U.S. (-8bps) and a full 25bp hike now priced in Sweden. Summing it all up, our simple Okun’s Law thought experiment shows that it would take a significantly larger decline in global growth than the consensus, or BCA, expects for central banks to shift even more dovishly in the direction of interest rate cuts. This puts a cyclical floor underneath global bond yields, given that relatively stable policy rates are now discounted. Bottom Line: The observed relationships between economic growth and changes in unemployment suggest that the current pullback in global growth will not be severe enough to create slack in labor markets and an easing of inflation pressures in the developed economies.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Given the declining productivity trend seen in all countries over the past 20 years, we have made a downward adjustment to those Okun’s Law estimated coefficients. In other words, we do not think that it will take the same magnitude of GDP loss to generate the same increase in unemployment when labor productivity is low. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hope Springs Eternal Hope Springs Eternal Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Investors like to hear non-consensus views, … : Part of our role is to help clients think about all of the potential outcomes, including ones that may not be as improbable as commonly believed. … but it seems that our Fed/rates call is starting to strike them as a little too non-consensus: Clients are having a hard time seeing the potential for inflation after ten years of errant predictions that it’s just around the corner. From our perspective, the probability of higher-rate outcomes is considerably higher than the probability of lower-rate outcomes, … : An investor with a low-duration bias has a whole lot more ways to win than an investor with a high-duration bias. … so we’re staying the course: We continue to recommend underweighting Treasuries and maintaining below-benchmark duration exposure, which aligns with our constructive take on markets and the economy. It’s too early to get defensive if a recession is at least a year away. Feature BCA clients like to hear contrarian calls, and there is little that’s more deflating from a strategist’s perspective than to be told in a meeting that his/her views are the same as everyone else’s. Except for the handful of strategists who make their living from provocative views that have almost no chance of coming to fruition, however, the calls have to be plausible. For many investors, our inflation concerns seem to be straining the bounds of plausibility. Even if BCA has only lately begun to beat the inflation drums, investors have had enough of warnings about inflation and interest-rate spikes that have repeatedly failed to come to pass. Regular readers are familiar with our contention that the sizable injection of fiscal stimulus into an economy already operating at capacity is a sure-fire recipe for inflation. They are also familiar with our view that an extremely tight labor market will necessarily give rise to robust wage gains. We have repeatedly argued that the Fed will respond to the combination of inflation pressures by hiking the fed funds rate above its equilibrium level, bringing the curtain down on the expansion and the equity bull market. With a Special Report examining the links between wage gains, consumer price inflation, and the Fed’s reaction function on the way, we’re instead devoting this week’s report to several other reasons why an investor would want to maintain below-benchmark duration in a fixed-income portfolio. Oil Prices Will Rise There is a good reason for devising core price indexes that smooth out the volatility inherent in food and energy prices. Core indexes provide a better read on the underlying inflation trend, and are a better predictor of moves in headline inflation than the headline indexes themselves. Inflation-linked Treasuries (TIPS) are tied to headline CPI, however, leaving the long-run inflation break-evens at the mercy of swings in oil prices (Chart 1). As we have previously written, our commodity strategists view the October-November swoon as a one-off event disconnected from market fundamentals that will quickly be unwound1 (Chart 2). Chart 1As Oil Goes, So Go Inflation Expectations, ... As Oil Goes, So Go Inflation Expectations, ... As Oil Goes, So Go Inflation Expectations, ... Chart 2... And Oil Prices Are Poised To Rise ... And Oil Prices Are Poised To Rise ... And Oil Prices Are Poised To Rise One need not fear that a rise in oil prices, while giving a fillip to headline inflation, would slow the economy and thereby offset inflation’s upward pressure on rates. Now that the U.S. is the world’s largest oil producer, its economy and financial markets are no longer negatively correlated with oil prices (Chart 3). It is still true that falling oil prices amount to a tax cut for American businesses and households, but they now also amount to fewer high-paying jobs in the oil patch, reduced earnings in an important domestic industry, and tighter monetary conditions as fracking bond spreads widen. Chart 3No Longer A Contrary Indicator No Longer A Contrary Indicator No Longer A Contrary Indicator Bottom Line: Higher oil prices will push headline inflation and inflation expectations higher, while also boosting the economy at the margin. The combination promotes higher bond yields, all else equal. The Economy’s Improved. Yields Haven’t Budged. Though we attributed the bulk of the fourth-quarter selloff to misplaced fears that the Fed was pulling the rug out from under the expansion, the economy was finding it harder and harder to produce positive surprises. By late January, however, the expectations bar had been reset low enough that new releases began surpassing it, day in and day out (until the end of last week). So far, though, the 10-year Treasury yield has stubbornly failed to reflect the improvement (Chart 4). Chart 4Surprises Turned Around, But Yields Didn't Surprises Turned Around, But Yields Didn't Surprises Turned Around, But Yields Didn't Financial conditions tightened sharply upon the sudden widening in corporate bond spreads and the sudden drop in equity prices. We viewed the seize-up as equivalent to at least a quarter-point increase in the fed funds rate and thereby found pausing to be a perfectly logical course of action for the Fed. The swiftness of the subsequent bounce in risk assets – the S&P 500 has retraced more than two-thirds of its losses and high-yield bonds have retraced close to 60% of their spread widening – has gone a long way toward undoing last quarter’s tightening. With the recovery in financial conditions, all three components of our Fed monitor now point to a need for tighter monetary conditions (Chart 5). Chart 5The Fed Can Pause, But It Can't Stop The Fed Can Pause, But It Can't Stop The Fed Can Pause, But It Can't Stop Adaptive Expectations’ Sluggish Response Investors’ inflation outlooks adhere closely to an adaptive expectations framework in which future predictions are largely a function of inflation’s recent path (Chart 6). This is not unreasonable; one could do a lot worse than pick the Patriots to reach the Super Bowl or only South American and European (ex-England) teams to win the World Cup. Adaptive expectations can fall prey to the recency bias, however, in which individuals overemphasize the most recent data points to the exclusion of older, potentially more representative data when forming their future views. From a recency-bias perspective, adaptive expectations can trap investors like the mythical frog contentedly lingering in a pot of water that’s only slowly brought to a boil. Chart 6Inflation Forecasts Take Their Cue From The Past ... Inflation Forecasts Take Their Cue From The Past ... Inflation Forecasts Take Their Cue From The Past ... We are skeptical of the notion that there will be no more inflation because there’s been no inflation since the crisis. The trend may be your friend, but not once the output gap has closed and the unemployment gap is persistently negative. Using the 10-year CPI forecast from the Philly Fed’s Survey of Professional Forecasters as an inflation-expectations proxy, one could argue that the lion’s share of the outsized gains in the pre-crisis phase of the bond bull market resulted from excessively generous inflation compensation (Chart 7, bottom panel). Chart 7... Which Is Great For Investors When Inflation Trends Lower ... Which Is Great For Investors When Inflation Trends Lower ... Which Is Great For Investors When Inflation Trends Lower The excessive compensation was a by-product of adaptive expectations. After the experience of the mid-seventies and early eighties (Chart 8), investors and issuers both assumed inflation would be higher than it turned out to be. Today’s bond-market participants, conditioned by ten years of soggy post-crisis readings, could well assume that inflation will be lower than it ultimately turns out to be. That may leave long-maturity bondholders with insufficient compensation, just like their early-fifties forebears. Chart 8Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Reversal Of Globalization The apex of globalization has been a key theme of our Geopolitical Strategy service since its launch. We cannot go as far as they sometimes do, arguing that globalization did more to bring inflation to heel than Paul Volcker, but it surely has been an important factor in limiting wage gains for low- and semi-skilled workers (Chart 9), and has helped to stymie retail price increases. The imposition of new tariffs have exacerbated globalization’s reversal, but it had already begun before the 2016 presidential election. The Reagan-Thatcher-Koizumi policies that were ascendant after the fall of the Berlin Wall, boosting global growth while tamping down inflation, have been in retreat in the developed world ever since the crisis. Chart 9China Syndrome China Syndrome China Syndrome Decomposing Core CPI When assessing inflation’s future direction, our U.S. Bond Strategy colleagues decompose the core CPI series into its primary components: Shelter (42% of the index); Goods (25%); Services, excluding shelter and medical care (25%); and Medical Care (8%). They then look at the drivers for each of the largest three components for an advance read on their future direction. Home price appreciation and the rental vacancy rate power their shelter costs model. With home price appreciation decelerating but still positive, and the rental vacancy rate hovering around its all-time lows, the model projects that shelter costs will remain well above 3% (Chart 10, top panel). Chart 10Core Inflation Isn't About To Melt Core Inflation Isn't About To Melt Core Inflation Isn't About To Melt Core goods inflation lags non-oil import prices by about a year and a half. The path of import prices suggests that core goods inflation will have a tailwind for much of the rest of the year before facing a headwind next year that will push it back to its current levels (Chart 10, second panel). Wage growth is the best predictor of core services inflation, ex-shelter and medical care (Chart 10, third panel). We expect continued upward pressure on services inflation, as labor-market slack continues to be absorbed, keeping wage growth accelerating. The Golden Rule Of Bond Investing Simplicity is a virtue in investment recommendations, models, and rationales, and our U.S. Bond Strategy colleagues’ golden rule of bond investing is elegantly simple.2 If Fed rate hikes exceed market expectations over a given time horizon, overweight duration positions will underperform over that horizon, and if Fed hikes fail to meet market expectations, overweight duration positions will outperform. Now that the money market has entirely priced out any rate-hike prospects over the next two years (Chart 11), overweight duration positions face a challenging backdrop. How will the fed funds rate surprise to the downside from here? Chart 11The Money Market Is Calling For A Rate Cut The Money Market Is Calling For A Rate Cut The Money Market Is Calling For A Rate Cut It can’t unless the Fed carries out more than one 25-basis-point cut in the next year or so. Given the underlying strength of the economy, gathering inflation pressures, and the swift unwinding of much of the tightening in financial conditions, rate cuts are a stretch. Against the current backdrop, the golden rule is a stern warning away from the longer-maturity reaches of the Treasury curve. Investment Implications We continue to stay the course with our fixed-income recommendations. If the Fed’s pause will extend the expansion for a few more months, it will extend the shelf life of our underweight Treasuries and overweight spread product recommendations, as well. As outlined above, we see many more potential catalysts for higher interest rates than we do for lower rates. We reiterate our recommendation that investors maintain below-benchmark duration across fixed-income segments. The expansion, and the bull markets in risk assets, will eventually end, but it’s too soon to position portfolios for it.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Does Oil’s Slide Mean?,” published November 26, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Highlights We would fade fears of an “earnings recession.” EPS growth should increase during the remainder of this year. While high debt burdens around the world may exacerbate deflationary pressures by restraining spending, they may also motivate policymakers to raise inflation in order to reduce the real value of outstanding debt. Ultimately, whether high debt levels turn out to be deflationary or inflationary depends on the extent to which policymakers have both an incentive and the means to increase inflation. The spread of political populism has made governments more inclined to boost nominal incomes by allowing economies to overheat. Central bankers have also become increasingly convinced that they should wait to see “the whites of inflation’s eyes” before tightening monetary policy any further. With inflation expectations still well anchored, it may take at least another 18 months for inflation in the U.S. to break out, and longer still elsewhere. Stay bullish on global stocks for now. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. Feature Fade Fears Of An “Earnings Recession” We upgraded global stocks in December following the post-FOMC meeting selloff. Our recommendation to go long the MSCI All-Country World Index has gained 9.0% since we initiated it. Although our enthusiasm for stocks has waned somewhat given the recent run-up, we continue to see upside for global bourses over the next 12-to-18 months. Admittedly, earnings growth has come down sharply from a year ago. To some extent, this reflects base effects (U.S. EPS rose by 23% in Q1 of 2018, thanks in part to the tax cuts). However, slower global growth and higher tariffs have also taken their toll. The good news is that the trade war is likely to stay on hiatus over the coming months. We also expect nominal GDP growth in the U.S. and the rest of the world to pick up by the middle of this year. Chart 1 shows that earnings growth tends to move in lock-step with nominal GDP growth. Chart 1Earnings And Nominal GDP Growth Move In Lock-Step Earnings And Nominal GDP Growth Move In Lock-Step Earnings And Nominal GDP Growth Move In Lock-Step Equity prices usually bottom when earnings growth bottoms (Chart 2). Analyst estimates based on IBES data foresee EPS growth troughing in Q1 and then accelerating modestly over the remainder of the year. If this happens, global equities will move higher over the coming months. Chart 2 What’s The Bigger Risk? Deflation Or Inflation? Last week, we argued that the next global economic downturn would probably be sparked by a surge in inflation which forces central banks to raise interest rates more aggressively than they would like.1 Given the absence of inflationary pressures today, and the still-ample spare capacity that exists in many economies, we noted that such an outcome is far from imminent. This implies that the global expansion still has plenty of room to run, thus justifying an overweight stance towards risk assets. One common objection to this thesis posits that deflation, rather than inflation, is the main risk to the global economy. And unlike its inflationary cousin, the next deflationary shock could be lurking just around the corner. Italy serves as a good example of the dangers of high debt levels. While many things can contribute to deflationary pressures, elevated debt levels are often cited as being the most important. An excessive debt burden can lead to a prolonged period of deleveraging. Since borrowers typically spend a larger share of their cash flows than lenders, overall spending could decline, leading to lower prices and wages. High debt levels can also make an economy vulnerable to interest-rate shocks. This is particularly the case when a country is reliant on external debt or issues debt in a currency it does not control. The Italian Lesson Italy serves as a good example of the dangers of high debt levels. Italy entered the euro area with one of the highest public debt ratios in the world. Private debt also soared in anticipation of euro membership as well as during the period leading up to the Global Financial Crisis, almost doubling as a share of GDP between 1998 and 2008 (Chart 3). Chart 3Italy's Debt Inferno Italy's Debt Inferno Italy's Debt Inferno Worries about high indebtedness, poor growth prospects, and contagion from Greece sent the 10-year Italian bond yield to nearly 7.5% on November 9, 2011. Yields tumbled after Mario Draghi pledged to do “whatever it takes” to preserve the common currency, but rose again last April after Italians brought an anti-austerity populist government into power. Today, the Italian government finds itself in the unenviable position of having to devote 3.4% of GDP to interest payments, more than double the euro area average (Chart 4). Domestic investors own less than half of Italian government debt, so most of those interest payments do little to stimulate domestic spending. Chart 4The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Inflation Solution When debt reaches elevated levels, faster nominal growth via higher inflation becomes an increasingly appealing solution for reducing debt ratios. A one percentage-point increase in nominal GDP will cut debt-to-GDP by half a percentage point when it stands at 50%, but by three full percentage points when it stands at 300%. Given the attractiveness of inflating away debt burdens, why don’t more governments pursue this strategy? Part of the answer is politics. The long history of hyperinflation in Europe and many other economies has cast a long shadow over how central banks operate. Unanticipated inflation also redistributes wealth from creditors to debtors. While the latter usually outnumber the former, the former typically have more political sway. Means And Opportunities Political will is a necessary condition for generating inflation, but it is not a sufficient one. Policymakers also need to possess the ability to accomplish their goal. What determines whether they will succeed? The answer, to a large extent, is the level of the neutral rate of interest. The neutral rate of interest is the long-term interest rate that is appropriate for the economy. When interest rates are above the neutral rate, growth will tend to fall below trend, while inflation will decline. Conversely, when rates are below their neutral level, the economy will grow at an above-trend pace and inflation will accelerate. Many things can influence the neutral rate of interest. These include: Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand. This will push up the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will push up the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require a lot of physical capital will tend to have a higher neutral rate of interest. By the same token, economies where the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest.  The exchange rate: A weaker exchange rate will boost net exports. This resulting increase in aggregate demand will translate into a higher neutral rate of interest. With the exception of the currency effect, all of the factors listed above are captured by the canonical Solow growth model which undergraduate economics students usually encounter in their studies (See Appendix 1 for a derivation of the neutral rate of interest in this model). Inflation And The Neutral Rate Economists tend to define the neutral rate in real terms. However, when thinking about inflation, it is useful to consider the neutral rate’s nominal counterpart. Conceptually, the nominal neutral rate of interest can be either negative or positive. When the nominal neutral rate is negative, even a policy rate of zero will be insufficient to allow the economy to overheat. One might call this outcome the “strong form” version of the secular stagnation thesis. In contrast, when the neutral rate is low, but still positive, an interest rate of close to zero will be low enough to allow the economy to overheat, which will eventually generate inflation. One may refer to this as the “weak form” version of the secular stagnation thesis. Political will is a necessary condition for generating inflation, but it is not a sufficient one. The Danger Of Strong-Form Secular Stagnation In situations where the strong form version of secular stagnation prevails, deflationary pressures will feed on themselves. If an economy suffers from a chronic shortfall of aggregate demand, inflation is liable to drift lower. A lower inflation rate will push down the nominal interest rate that is consistent with any given real rate. For example, if the economy requires a real rate of -1% in order to grow at trend and inflation is 2%, a 1% nominal rate will suffice. But if inflation is 0%, then the policy rate would need to be -1%, which may be difficult to achieve. Japan serves as a case study for how this vicious circle can unfold. Following the simultaneous bursting of the property and stock market bubbles in the early 1990s, the Japanese private sector entered a prolonged deleveraging cycle. Inflation drifted steadily lower, ultimately falling into negative territory during the 1997-98 Asian Crisis (Chart 5). High debt levels in Japan were deflationary because the nominal neutral rate of interest was negative. Even if the Bank of Japan wanted to, it was greatly constrained in its ability to raise inflation. Chart 5Japan: A Case Study In Strong-Form Secular Stagnation Japan: A Case Study In Strong-Form Secular Stagnation Japan: A Case Study In Strong-Form Secular Stagnation Europe Is Not Japan… Yet Next to Japan, the euro area comes the closest to meeting the criteria for strong form secular stagnation. The euro area has low trend growth, owing to its slow population growth rate, as well as a banking system that is still focused on deleveraging. There is a silver lining, however: Despite the many woes the euro area has experienced, long-term inflation expectations are still over 100 basis points higher than in Japan (Chart 6). Fiscal policy is also turning somewhat more accommodative. Our base case is that the ECB will be slow to unwind its balance sheet and will only raise rates if the economy is showing more verve. This should be enough to move inflation towards target over the next two years. Chart 6Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Inflation In The U.S. When inflation does break out early next decade, it will probably happen first in the United States. A large structural budget deficit and the revival of credit growth to the household sector following an intense period of deleveraging have boosted the neutral rate of interest. An overheated labor market is driving up real wages, which will lead to more consumer spending. December’s weaker-than-expected retail sales report will prove to be a fluke. Not only was it influenced by the sharp drop in the stock market and worries about a pending government shutdown (both of which have reversed), but the report itself was probably compromised by delays in the collection of data, which may have pushed some responses into January (historically, the weakest month for retail sales). This interpretation is consistent with strong holiday sales reported by online retailers and solid growth in the Johnson Redbook index of same-store sales. The latter captures over 80% of the sales surveyed by the Department of Commerce in its retail sales report, and featured a 9.3% year-over-year increase in sales in the final week of December, the fastest since the start of this series in 1997 (Chart 7). Chart 7The December Retail Sales Report Was Probably A Fluke The December Retail Sales Report Was Probably A Fluke The December Retail Sales Report Was Probably A Fluke Yes, corporate debt in the U.S. is high, but it is not particularly elevated relative to most other countries (Chart 8). Despite the collapse in equity prices and the spike in credit spreads late last year, U.S. corporations are still eager to expand capacity (Chart 9). This is not an economy teetering on the brink of recession. Chart 8U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards Chart 9U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Whether it be Trump’s unfunded tax cuts or the “Green New Deal” championed by the more liberal members of the Democratic Party, fiscal stimulus is in, austerity is out. Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Even mainstream voices have given their nod of approval. Just this week, former IMF Chief Economist Olivier Blanchard argued that the U.S. could safely increase public debt without endangering economic stability.2 Meanwhile, central banks have increasingly bought into the mantra, famously espoused by Larry Summers, that they should wait to see the “the whites of inflation’s eyes” before tightening monetary policy.3 What this mantra overlooks is that inflation is a highly lagging indicator. By the time you see the whites of a tiger’s eyes, you are already destined to be its dinner. Investment Conclusions The spread of populist economic policies offers a one-two punch to inflation. Not only are populist prescriptions apt to stimulate demand, but that stimulus will raise the neutral rate of interest, thereby giving central banks greater traction to further boost spending by keeping rates below their neutral level. For investors, this implies a dichotomy between the medium-term and longer-term asset market outlook. Easy money policies are a boon to risk assets when they are first introduced, as they typically combine low interest rates with fast nominal GDP growth. But the path to higher rates is lined with lower rates, meaning that the longer central banks keep rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. As such, investors should overweight global equities and high-yield credit for the next 12 months. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. In terms of regional equity allocation, we continue to see global growth bottoming by the middle of this year. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. The resulting reflationary impulse will be manna from heaven for the more cyclically-sensitive sectors of the stock market, as well as Europe and EM. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Image   Laura Gu Research Associate Footnotes 1      Please see Global Investment Strategy Weekly Report, “Minsky’s Corollary,” dated February 8, 2019. 2       Olivier Blanchard, “Public Debt and Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019); Noah Smith, “The U.S. Can Take on a Lot More Debt Within Limits,” Bloomberg Opinion, (February 2019). 3      Lawrence Summers, “Only raise US rates when whites of inflation’s eyes are visible,” Financial Times, (February 2015). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 10 Tactical Trades Strategic Recommendations Closed Trades

Highlights Treasury Yields & Data Surprises: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Positioning data show no long or short consensus among bond investors, but we think below-benchmark portfolio duration will pay off over both short term (0-3 months) and medium term (6-12) investment horizons. Monetary Policy: The Fed cited tighter financial conditions and slower global growth as the two main reasons for pausing the rate hike cycle. Both of those risks appear poised to ease in the coming months. Expect rate hikes to resume in the second half of 2019. Inflation: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers. Feature It didn’t take very long. Just two days in fact. Two days after Chairman Powell made the Fed’s pause official we learned that the economy added 304k jobs in January (vs. 165k expected) and that the ISM Manufacturing PMI rebounded to a very healthy 56.6 (vs. 54.0 expected). In short, just as the Fed capitulated on rate hikes, the economic data made that decision look offside. Granted, the bond market does not yet see it this way. The economic data surprise index has moved firmly into positive territory, but Treasury yields have so far refused to follow suit, bucking the typical correlation (Chart 1). Still, we can’t help but feel that consensus economic expectations remain overly downbeat, and that this could set the bond market up for a nasty near-term shock. Chart 1Market Set Up For A Surprise Market Set Up For A Surprise Market Set Up For A Surprise Bond Market At Risk In prior research, we documented the strong correlation between economic data surprises and changes in the 10-year Treasury yield.1 We found that if the U.S. economic surprise index ends a given month in positive territory, there is a good chance that the 10-year Treasury yield increased during that month, and vice-versa (Chart 2A). This relationship also holds reasonably well for 3-month and 6-month investment horizons (Charts 2B & 2C). Chart 2 Chart 2 Chart 2 This is a good thing to know, but it is only useful if we can also predict future economic data surprises. That is certainly no easy task. However, we can exploit what we know about market behavior to give ourselves a slight advantage. For instance, we know that investors revise down their economic expectations after a long string of data disappointments, making it easier for future data to surprise on the upside. Similarly, a long string of positive data surprises usually leads to unrealistically strong expectations, setting the market up for a letdown. This dynamic causes the economic surprise index to be a mean reverting series, and we find that we can explain 55% of its historical variation using the following 3-factor auto regressive model: ESIt+1 = 0.87*(ESIt) – 0.25*(ESIt-1) – 0.16*(ESIt-2), where ESIt is the surprise index’s value in the current month Notice that next month’s index value is a positive function of the current month’s value, but a negative function of the values from each of the prior two months. At present, our model predicts that the surprise index will reach 18 one month from now (see the ‘X’ in Chart 1). As shown in Table 1, a reading of 18 from the surprise index coincides with a higher 10-year Treasury yield 53% of the time. Table 1End-Of-Period Surprise Index Levels And Whether The 10-Year Yield Rose Or Fell During That Period (2003 – Present) Caught Offside Caught Offside Bond Market Positioning Investor positioning and data surprises are closely related concepts. When investor economic expectations are downbeat, it is highly likely that bond market participants also carry a lot of duration risk. A large “net long” duration exposure can make the ensuing bond sell-off worse when the data inevitably surprise to the upside. At present, the JPMorgan Duration Survey shows that investors are neither severely long nor short duration risk (Chart 3). Speculators in 10-year Treasury futures are slightly net short (Chart 3, panel 2), and sentiment surveys report that investors are somewhat bearish on bonds (Chart 3, bottom panel). In general, positioning still has a slightly bearish tinge, but is much closer to neutral than it was a few months ago, prior to the sharp plunge in yields. Chart 3Positioning Close To Neutral Positioning Close To Neutral Positioning Close To Neutral Bottom Line: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Extreme “net long” bond market positioning would exacerbate any related near-term sell-off, but surveys indicate that positioning is close to neutral. This leads us to expect higher yields in the next few months, but no major market dislocation. The Fed’s Dovish Pivot We have not published a regular Weekly Report since the FOMC signaled a pause in its rate hike cycle on January 30. Since then, many have speculated that the Fed’s rate hike cycle is already over and the market has eagerly taken that message on board. As of last Friday’s close, the overnight index swap curve was priced for 11 bps of rate cuts during the next 12 months and 23 bps of rate cuts during the next 24 months. Data Dependence  Unfortunately for bond bulls, the case for rate cuts is simply not supported by the economic data. In fact, a look at the reasons used to justify the Fed’s dovish pivot reveals that the pause in rate hikes will almost certainly prove temporary. In his post-meeting press conference, Chairman Powell attributed the Fed’s dovish turn to the following factors: Tighter financial conditions Slower global growth Government-related risks (i.e. Brexit, U.S./China trade discussions, and the U.S. government shutdown) Financial Conditions Financial conditions tightened sharply near the end of last year, as can been seen by looking at the three components of our Fed Monitor (Chart 4). Our Fed Monitor is a composite indicator designed to predict whether rate hikes or rate cuts are more likely going forward. It includes 44 variables related to either economic growth, inflation or financial conditions. Chart 4Financial Conditions Have Already Eased Financial Conditions Have Already Eased Financial Conditions Have Already Eased The most important thing to note from Chart 4 is that all of the Monitor’s recent decline was driven by tighter financial conditions. The economic growth and inflation components of the Monitor remain firmly in “tight money required” territory. This is important because financial conditions can ease as quickly as they can tighten. Ironically, now that the Fed has telegraphed a more supportive policy stance, a rally in risk assets during the next few months is much more likely. As that transpires it will drive our Monitor deeper into “tight money required” territory, and rate hikes will be back on the table. Global Growth The second factor that Powell mentioned was the slowdown in global growth, driven principally by weakness in China and the Eurozone (Chart 5). Interestingly, at the European Central Bank’s (ECB) latest press conference, ECB President Mario Draghi also blamed “softer external demand” for the weakness in European economic data. Chart 5Global Growth Slowdown Driven By China Global Growth Slowdown Driven By China Global Growth Slowdown Driven By China The logical conclusion is that China has been the catalyst for the global slowdown and that the Eurozone economy has come under pressure because of that region’s greater reliance on China as a source of demand. The fact that the Eurozone is more sensitive to Chinese growth than the U.S. is a topic that our Foreign Exchange Strategy service has covered in great detail.2 The Fed obviously cares more about the domestic economy than overall global growth, but weakness abroad has a habit of migrating stateside via a stronger dollar.3 It would certainly help the case for rate hikes if Chinese (and hence global) growth at least stabilized. On that front, some timely global growth indicators are sending positive signals. Our China Investment Strategy team’s Market-Based China Growth Indicator has rebounded strongly (Chart 6), global industrial mining stock prices have jumped (Chart 6, bottom panel), and the CRB Raw Industrials index may finally be turning a corner (Chart 6, panel 2).4 Chart 6Global Growth Indicators Sending A Positive Signal... Global Growth Indicators Sending A Positive Signal... Global Growth Indicators Sending A Positive Signal... But for any rebound in those financial market indicators to prove lasting, we will ultimately need to see confirming evidence in the Chinese economic data. Specifically, the money and credit growth data that tend to lead Chinese economic activity (Chart 7). Our China Investment Strategy team’s Li Keqiang Leading Indicator – a composite of six money and credit growth indicators – has flattened off at a low level. Looking at its components individually, those that capture the recent RMB depreciation have pressured the index higher (Chart 7, panel 2), while those that measure broad credit growth remain depressed (Chart 7, bottom panel). Our Global Investment Strategy team has argued that Chinese policymakers’ desire to suppress credit growth will soon abate, since credit growth has already fallen close to the rate of nominal GDP growth.5 Chart 7...But A Lot Depends On China ...But A Lot Depends On China ...But A Lot Depends On China Bottom Line: It seems increasingly likely that financial conditions will ease and that the global growth slowdown will moderate in the coming months. Geopolitical tail risks remain, but they are unlikely to impact the Fed’s reaction function if financial conditions are easing and global growth is on solid footing. The end result is that the Fed will resume rate hikes in the second half of this year, and Treasury yields will move higher as a result. Investors should maintain below-benchmark portfolio duration. The End Of QT At January’s press conference, Chairman Powell was also quizzed repeatedly about the Fed’s balance sheet policy. This is not surprising given that the Fed had just announced that it will operate monetary policy using its current “floor system” indefinitely. This means that it will continue to supply the banking system with more reserves than it demands, and will control interest rates by paying interest on excess reserves and through the overnight reverse repo facility. We explained in detail the differences between a floor system and the pre-crisis “corridor system” in a 2014 Special Report.6 Practically, the continuation of the floor system means that the Fed’s balance sheet run-off will end earlier than if it were to return to a corridor system. The latter requires a paucity of bank reserves while the former requires an abundance. Unfortunately, as we discussed in a recent report, and as Chairman Powell explained at his press conference, nobody knows exactly how much more reserve drainage can take place before the Fed’s floor system ceases to function and the Fed loses control of interest rates.7 From Powell’s press conference: [I]n managing the federal funds rate, we’d rather have it set by our administered rates. So that implies you’d want [outstanding bank reserves] to be a bit above what that equilibrium demand for reserves is. And again, there’s no cookbook here, there’s no playbook. No one really knows. The only way you can figure it out is by surveying people and market intelligence and then, ultimately, by approaching that point quite carefully. In other words, the Fed will continue to shrink its balance sheet – draining reserves from the banking system in the process – until it decides that any further reserve drain will cause the funds rate to break through the upper-end of its target band. There is already some evidence of pressure on this front. The effective federal funds rate has been inching toward the upper-end of its target range in recent months, and the 99th percentile of the daily effective fed funds rate has actually been above the target range. This means that, for the past couple months, a few federal funds transactions every day have occurred outside the Fed’s target range (Chart 8). If this situation persists, then it will hasten the Fed’s decision to cease the run-off of its balance sheet. Chart 8Fed Funds Rate Inching Higher Fed Funds Rate Inching Higher Fed Funds Rate Inching Higher Our sense is that the Fed will cease the unwinding of its balance sheet at some point this year or early next year. However, we don’t view that decision as very important from an investment standpoint. It has been the longstanding view of this publication that any possible impact on bond yields from the Fed’s balance sheet policy pales in comparison to the impact from its interest rate policy. We will elaborate on this view in forthcoming research alongside our Global Fixed Income and U.S. Investment Strategy services. For today, we will simply remind readers of our golden rule of bond investing: If Fed rate hikes exceed what is currently priced into the market, then long duration positions will underperform over that time horizon, and vice-versa.8 All other factors are subordinate to that golden rule. Will Tame Inflation Prevent Further Rate Hikes? At January’s press conference, Chairman Powell noted that one reason why the Fed felt comfortable pausing its rate hike cycle was that inflation appeared relatively tame. Once again, the Chairman accurately described the fact that year-over-year core inflation has moderated during the past few months. Year-over-year core CPI inflation is down to 2.21% as of December, from a peak of 2.33% last July. Data on the Fed’s preferred PCE measure has been delayed due to the government shutdown, with a December update expected on March 1. However, this is another situation where the evidence could look a lot different in a few months. The last three monthly core CPI prints have come in at right around 0.2% month-over-month. If that pace is maintained going forward, then year-over-year core CPI will fall a bit further in the near-term, but will then start rising at a rapid pace (Chart 9). By the middle of this year the discussion surrounding inflation could look a lot different. Chart 9Expect Inflation To Pick-Up By The Middle Of The Year Expect Inflation To Pick-Up By The Middle Of The Year Expect Inflation To Pick-Up By The Middle Of The Year Of course, the simple extrapolation in Chart 9 assumes that core inflation will continue to print at a 0.2% monthly rate. Given the low unemployment rate, accelerating wage growth and persistent elevated monthly hiring numbers, we see no reason why this shouldn’t be the case. However, many clients we talk to have strong doubts that core inflation will move higher. This sentiment is reflected in long-maturity TIPS breakeven inflation rates that remain well below “well anchored” levels. One of the most common questions we receive from clients is: Where will inflation come from? A good starting point to answer that question is to split core CPI into its main components (Chart 10): Chart 10The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Shelter (42% of core) Goods (25% of core) Medical Care (8% of core) Services excluding shelter and medical care (25% of core) After making this decomposition we can attempt to identify unique drivers for each component. For shelter inflation, the rental vacancy rate and home price appreciation are the most important variables. Home prices have decelerated in recent months but the rental vacancy rate remains near historically low levels. Taken together, our shelter CPI model shows that shelter inflation should stay near its current level for the next six months (Chart 10, top panel). Core goods inflation tends to track non-oil import prices with a relatively long lag (Chart 10, panel 2). The current message from import prices is that core goods inflation should level off in the coming months, but should not reverse its recent uptrend. The best determinant of trends in core services (excluding shelter and medical care) inflation is wage growth (Chart 10, panel 3). Here we see that services inflation has responded strongly to accelerating wage growth in recent months and is now running at a healthy 2.6% year-over-year pace. With the unemployment rate at 4%, further wage acceleration is probable. Bottom Line: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And Risk Assets Are Beholden To China’s Stimulus”, dated August 3, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 4 The Market-Based China Growth Indicator is a composite measure of financial market variables that are highly levered to the Chinese economy. For further details please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “China’s Savings Problem”, dated January 25, 2019, available at gis.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, “Cleaning Up After The 100-Year Flood”, dated June 10, 2014, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification