Japan
Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. The message now conveyed by the Monitors is that divergences between the cyclical pressures faced by the individual central banks are growing larger. This is occurring within some countries, where the growth and inflation indicators are trending in opposite directions. This is also visible across countries, with not every Monitor calling for rate hikes - a significant shift from the coordinated backdrop seen in 2017 (Chart of the Week). Chart of the WeekFrom Convergence To Divergence In The BCA Central Bank Monitors The combined message from the Monitors is that the slower pace of global growth seen in 2018 has not been enough put a serious dent in inflation pressures stemming from a dearth of spare capacity in most major countries. Perhaps that changes if a full-blown U.S.-China trade war develops, or if the tensions in emerging markets spill over more broadly into global financial conditions, but that remains to be seen. Add it all up, and a below-benchmark stance on overall global duration exposure remains appropriate. Feature An Overview Of The BCA Central Bank Monitors Chart 2CB Monitor Divergence = Bond Yield Divergence The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocation for global government bonds reflects the trends seen in the Central Bank Monitors - underweighting countries were the Monitors are most elevated (the U.S., Canada) in favor of regions where the Monitors are lower (Australia, Japan, euro area, New Zealand). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against the relative returns for each country versus the overall Bloomberg Barclays Global Treasury index (shown inversely in the charts so that a rising line means underperformance versus the benchmark index). Fed Monitor: Still On A Gradual Rate Hike Path Our Fed Monitor remains in the "tight money required" zone, signalling that the cyclical backdrop justifies additional Fed rate hikes (Chart 3A). Resilient U.S. growth, a dearth of spare capacity and an acceleration of both wage growth and core inflation are all consistent with a U.S. economy starting to overheat and requiring tighter monetary policy (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BU.S. Inflation On The Rise The growth and inflation components of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published back in April. Most notably, the inflation component has blasted through the zero line to the highest level since 2008 (Chart 3C). The financial conditions component has retreated from very elevated (i.e. growth-supportive) levels, mostly due to the stronger U.S. dollar but also because of wider corporate credit spreads seen since the start of 2018. Importantly, the financial conditions component has not tightened enough to offset the impact on the Monitor from faster growth and inflation. Chart 3CAll Fed Monitor Components Now Above Zero Recent comments from senior Fed officials (Chair Jay Powell and Governor Lael Brainard) have indicated that the Fed is less confident in its own estimates of the full-employment NAIRU or the appropriate neutral level of the funds rate. Our read on this is that the Fed will instead continue to raise the funds rate at a gradual 25bp per quarter pace until there are signs that U.S. monetary policy has become tight (i.e. an inverted yield curve, wider credit spreads, softer U.S. economic data). Until then, the message sent by the Fed Monitor is to remain underweight U.S. Treasuries with below-benchmark duration, as market pricing of expectations for both the funds rate and inflation remain too low (Chart 3D). Chart 3DU.S. Treasury Underperformance Will Continue - Stay Underweight BoE Monitor: Brexit Uncertainty Trumps Inflation Pressures The BoE Monitor remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has kept monetary policy at highly accommodative levels, only raising the base rate 50bps over the past year. The BoE Monetary Policy Committee remains torn between signs that inflation risks are tilted to the upside and the downside risks to U.K. growth from an uncertain Brexit outcome. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, with core inflation drifting back below 2%. Wages are finally starting to grow in real terms, which the BoE cites as an important factor underpinning consumer spending, but the pace remains modest. Chart 4AU.K.: BoE Monitor Chart 4BNo Spare Capacity, Yet Has Inflation Peaked? Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator have recently reaccelerated (Chart 4C). Yet U.K. leading economic indicators continue to decline and dampened business confidence measures reflect the heightened uncertainty over the future relationship between the U.K. and the European Union. Chart 4CBoth Growth & Inflation Components Are Boosting The BoE Monitor The performance of U.K. Gilts has diverged from the Monitor since the 2016 Brexit vote (Chart 4D), as the BoE has been more worried about Brexit than inflation and has stayed accommodative. Stay overweight U.K. Gilts within global government bond portfolios, even with the more bearish signal implied by our BoE Monitor, given the weakening trend in leading economic indicators and persistent Brexit uncertainty. Chart 4DBrexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts ECB Monitor: No Pressure To Hike Rates Quickly Post-QE Our European Central Bank (ECB) Monitor has fallen sharply since we last published this Chartbook back in April, and it now sits below the zero line (Chart 5A). The growth deceleration in the first half of the year from the rapid pace seen in 2017 is the main reason for this move, as inflation pressures have not subsided (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area At Full Capacity ECB President Mario Draghi noted last week that the plan remains in place to end the net new buying phase of the ECB's Asset Purchase Program at the end of 2018. Policymakers' have grown more confident that their inflation forecasts will be met as most measures of euro area wage growth (and headline inflation) have accelerated to 2% over the past year. It remains to be seen if those expectations are too optimistic, as the growth component of our ECB Monitor remains well below the zero line, while the inflation component is no longer rising (Chart 5C). Chart 5CGrowth Component Dragging Down The ECB Monitor For now, we recommend a neutral stance on core euro area government bonds with an underweight posture on Peripheral sovereign debt as a way to manage these conflicting trends. The overall performance of euro area bonds versus global benchmarks has followed the pace of the ECB's bond-buying since 2015, and not the pressures suggested by our ECB Monitor (Chart 5D), suggesting a bearish stance as the bond buying ends. Yet from a more bullish perspective, the mixed message on growth and lack of immediate pressures on core inflation (still at 1%) imply that the ECB will not deviate from its current dovish forward guidance of no interest rate hikes until at least September 2019. Chart 5DECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds BoJ Monitor: Too Soon To Consider Policy Changes Our Bank of Japan (BoJ) Monitor has stayed just barely in the "tighter money required" zone since last October, due mostly to growing inflation pressures (Chart 6A). Yet with the Japanese labor market now as tight as it has been in decades, headline and core CPI inflation are only at 0.9% and 0.3% respectively, well below the BoJ's 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BInflation Pressures Slowly Building In Japan Japanese firms appear to finally be reacting to the tightness of the labor market, however, as wage growth has accelerated in recent months. The pick-up in wages has helped boost inflation expectations, both of which are part of the inflation component of the BoJ Monitor that is now at the highest level since 2008 (Chart 6C). However, the growth component just rolled over and now sits at the zero line, as the Japanese economy has lost some momentum. Chart 6CInflation Boosting BoJ Monitor We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings - especially compared to the rest of the developed markets - until there is much higher realized inflation in Japan. JGBs have indeed been outperforming over the past year, even with the less dovish signal sent by the BoJ Monitor (Chart 6D). Yet the absolute level of the Monitor remains around zero, suggesting that no policy changes should be expected. That means no upward adjustment of the BoJ's 0% yield target on 10-year JGBs or major further reductions in the annual pace of BoJ JGB buying (even though the central bank is hitting capacity constraints as it now owns close to ½ of all outstanding JGBs). Chart 6DBoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoC Monitor: Rate Hikes - More To Come The Bank of Canada (BoC) Monitor has stayed in "tighter money required" since the beginning of 2017 and is now well above the zero line (Chart 7A). The BoC has been following our BoC Monitor, hiking rates by a cumulative 100bps since July 2017. Chart 7ACanada: BoC Monitor Chart 7BAn Overheating Canadian Economy? The BoC has been responding to the growing inflation pressure in Canada. There is no evidence that spare economic capacity exists, while realized inflation is near the upper bound of BoC's target range of 1-3% (Chart 7B). There is a growing divergence between the growth and inflation subcomponents of the BoC Monitor, with the latter decelerating over the past several months. That was due to a combination of slowing Chinese import demand and the imposition of trade tariffs on Canada by the Trump administration (Chart 7C). Yet the domestic economy remains in good shape, with the overall indicator from the BoC's Business Outlook Survey at the highest level since 2010. Chart 7CInflation Component Boosting BoC Monitor We continue to recommend an underweight stance on Canadian government bonds, as the relative performance has broadly followed the path of the BoC Monitor over the past three years (Chart 7D). The BoC tends to follow the policy actions of the Fed with a short lag, thus our bearishness on Canadian government bonds is related to our more hawkish views on the Fed. Yet the surge in Canadian inflation, at a time when the economy has no spare capacity, suggests that there are good domestic reasons to expect more rate hikes from the BoC over the next year than what is currently discounted by markets. Chart 7DBoC Not Done Yet - Stay Underweight Canadian Bonds RBA Monitor: Easier Policy Needed The Reserve Bank of Australia (RBA) monitor has rapidly fallen below the zero line for the first time since 2016, and now indicates that easier monetary policy is required (Chart 8A). This stands out from the more stable trajectory of the rest of the BCA Central Bank Monitors. Unlike most other developed countries, there is still excess capacity in the Australian economy. Australia's output gap has not closed while the current unemployment rate is just at the OECD's NAIRU estimate of 5.3%. Headline and core inflation are at the low end of the RBA's 2-3% target and struggling to gain much upward momentum (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BMinimal Inflation Pressure In Australia While both the growth and inflation components of the RBA Monitor have fallen, the biggest decline has come from the inflation side (Chart 8C). The sluggishness of Australia's economy is due to the slow growth of consumer spending and a big deceleration in exports related to softer Chinese demand. On inflation, excess labor market slack, with an underemployment rate close to 8.5%, is the main factor explaining soft wage growth and overall sluggish inflation. Chart 8CInflation Component Weighing On RBA Monitor Our highest conviction country allocation call this year has been to overweight Australian Government bonds, and we see no need to change that given the bullish signal from our RBA Monitor (Chart 8D). It would likely take a rise in unemployment, a renewed decline in realized inflation or a big external shock for the RBA to actually cut rates as our Monitor suggests, but the signal is still bullish for Australian debt on a relative basis. Chart 8DRBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBNZ Monitor: Policy On Hold For A While Longer The Reserve Bank of New Zealand (RBNZ) Monitor is currently just above the zero line, indicating that tighter monetary policy is required (although just barely) (Chart 9A). This is consistent with the mixed messages in the New Zealand economic data. For example, there is no spare capacity in the economy according to estimates of the output and employment gaps, yet both headline and core inflation have decelerated to the lower end of the RBNZ's 1-3% target band (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BNo Spare Capacity In NZ, But No Inflation Either Looking at the components of the RBNZ Monitor, the growth factors have continued to plunge whereas the inflation factors have been increasing (from below zero) since the start of 2018 (Chart 9C). New Zealand's economic growth has slowed because of softer consumer spending and weaker housing activity, the latter of which is related to lower net immigration. Yet business confidence is falling, both the manufacturing and services PMIs have also declined, and export growth has cooled thanks to weaker growth from China and Australia. Meanwhile, the uptick in the inflation components has not yet translated into any broader improvement in realized inflation that would cause the RBNZ to take a more hawkish turn. Chart 9CConflicting Trends Within The RBNZ Monitor We continue to recommend an overweight stance on New Zealand Government Bonds, in line with the bullish signal sent by our RBNZ Monitor (Chart 9D). The RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will stay unchanged until 2020, and it will take some time before there is evidence that the recent hook down in inflation is nothing more than a temporary blip. Chart 9DRBNZ To Remain On Hold - Stay Long New Zealand Bonds Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Chart I-3EM Debt Exposure In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book Chart I-11U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors 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 Real Rate "Targeting": Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. U.K.: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Japan: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Feature Chart Of The WeekA 'New, New Normal' Of Higher Real Rates? Three major central banks met last week and, surprisingly, the most important message did not come from the Federal Reserve. The Bank of England (BoE) and Bank of Japan (BoJ) both delivered policy decisions that appeared more hawkish on the surface, even though the underlying message was far more mixed. The BoE hiked rates by 25bps, while the BoJ tweaked its yield curve control policy by raising the allowable ceiling for the 10-year Japanese Government Bond (JGB) to 0.2%. Yet both central banks signaled - through published research, commentary and outright forward guidance - that the timing of the next policy move is uncertain. This contrasts with the Fed, who continues to signal a slow-but-steady path of U.S. rate hikes over at least the next year. The BoE and BoJ are dealing with the same issues that all the major developed market central banks are facing now - how to reconcile low unemployment and an apparent dearth of spare economic capacity with only modest upward inflation momentum and real interest rates that appear too low (Chart of the Week). Against that backdrop, the communication of central banker strategies to the public, and to the financial markets, is critical to their success, defined by keeping inflation stable around target levels. The Fed has been a leader in introducing nuance into the execution, and communication, of post-crisis policymaking. First, by focusing more on underutilized capacity in the U.S. labor market to justify keeping the funds rate low despite the headline unemployment rate falling below its estimate of "full" employment. Later, by focusing attention on real interest rates and the possibility that the neutral level of that rate (a.k.a. "r-star") can vary cyclically from levels that would previously have been considered consistent with full employment and stable inflation. In both cases, the Fed has provided a framework that allows some wiggle room as it continues to normalize away from crisis-era policy settings. Passionate advocates of the concept like current New York Fed President John Williams have led the Fed's growing focus on r-star. Yet in its latest Inflation Report published last week, the BoE dedicated five full pages to the topic of estimating r-star in the U.K.1 Other central banks have discussed their own estimates of r-star over the past year, as well.2 This is an important point for global bond markets. If other central banks begin to follow the lead of the Fed and elevate the importance of "real rate targeting" into their inflation targeting frameworks, then real bond yields could have significant upside with policy rates still not above realized inflation in the major developed economies. This will especially be true if factors that have kept r-star cyclically depressed in many countries in the post-crisis era - weak productivity growth, fiscal consolidation, excess capacity in labor markets, household deleveraging, among others - continue to slowly dissipate. At the moment, the most important themes for global financial markets relate to the ongoing Fed tightening cycle, the potential for policy stimulus in China in response to slowing domestic growth, and the slowing growth of central bank balance sheets (Chart 2). All three are bond bearish. We could add a fourth item to that list - U.S. protectionism, which can lead to slowing global through diminished trade activity. While there is evidence from many countries that a more uncertain outlook for global trade has negatively affected business confidence, there is also some tentative evidence that the deceleration in global trade activity may be in the process of stabilizing (Chart 3). Yet even if the U.S. - China trade tensions worsen and industrial activity slows further, tariffs and trade barriers represent a supply shock that could result in higher global inflation and prevent a meaningful decline in bond yields. Summing it all up for our government bond investment strategy, we continue to recommend: a below-benchmark overall portfolio duration stance country allocation (Chart 4) with underweight exposure to countries where central banks can credibly raise interest rates (U.S., Canada) and overweight exposure where rate hikes will be more difficult to deliver (U.K., Japan, Australia) Bottom Line: Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. Chart 2The Biggest Market Risks Are Bond Bearish Chart 3Tentative Signs Of Global Trade Stabilization? Chart 4Underweight Countries That Can Credibly ##br##Raise Rates (And Vice Versa) Stay Overweight U.K. Gilts, Even After The BoE Rate Hike The BoE delivered a 25bp rate hike last week, bringing its Bank Rate to 0.75%. The growth and inflation forecasts for the next three years were essentially unchanged, however. The hike was described by BoE Governor Mark Carney as a sign of growing confidence by the Monetary Policy Committee (MPC) in its forecast. Thus, another step towards normalizing the Bank Rate from accommodative levels was appropriate. In the press conference following the MPC meeting, Carney noted that the recent pickup in U.K. wage growth was an important development. Carney said that with the economy at full employment,3 the BoE's job is to "manage demand" to control inflation while nominal wage growth expands. Real wage growth has crept back into positive territory in recent months (Chart 5). Numerous indicators were presented in the August 2018 Inflation Report to suggest that U.K. labor markets are growing increasingly tight - including faster wage growth for those switching jobs than those staying in jobs (bottom panel) and survey data showing greater pay increases in sectors facing recruitment and retention difficulties. The BoE did downplay the recent cooling of realized U.K. inflation, which has been more a product of the stability of the pound than an easing of domestic inflation pressures. While this is true, market-based measures of inflation expectation like CPI swaps have also been following the path of the pound, rather than typical forces like oil prices, since the collapse in the pound after the 2016 Brexit vote (Chart 6). On the margin, however, the more stable pound means that U.K. inflation will be more influenced by domestic factors, like tight labor markets and wage pressures. Chart 5Mixed Signals From The U.K. Labor Market Chart 6U.K. Inflation Following The Pound, Not The Labor Market As discussed earlier, the BoE did devote a significant section of the latest Inflation Report to the topic of the neutral real rate or r-star. The BoE noted that there was a longer-term and shorter-term r-star, and that the latter had to be deeply negative in recent years given the shocks from the 2008 Financial Crisis and recession to the 2016 Brexit vote to the fiscal austerity of recent Conservative governments. As the impacts of those shocks fades, the shorter-term r-star increases, requiring faster BoE rate hikes. Or as it was described in the Inflation Report: "The expected rise in r* over coming years, combined with the absorption of spare capacity over the forecast period, means that - even as inflation is projected to fall back toward 2% - the Bank Rate is likely to need to rise gradually to keep inflation at the target. But the persistence of the fall in the trend real rate means that any rises in the Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come." That sounds like the BoE wanting to have its cake and eat it too, talking up rate hikes while making the case for rates to stay low for longer. The longer-run r-star estimates shown in the Inflation Report (between 0.5% and 1.5%) when added to the 2% BoE inflation target, suggests that the neutral nominal Bank Rate is between 2.5% and 3.5%. That does imply that there is a lot of scope for additional BoE rate hikes without even reaching a level that could be considered "'neutral' from a longer-term perspective" (Chart 7). It will be difficult for the BoE to deliver on any additional rate hikes, however, while both the economy and inflation are decelerating. The current pricing in the U.K. Overnight Index Swap (OIS) curve shows that there are only 42bps of hikes discounted by the end of 2020. That represents a very low hurdle to overcome, even if the U.K. economy remains sluggish and the Brexit outcome turns ugly. From a strategy perspective, we think that Gilt yields can rise above the current shallow path of the forward curve over the next 6-12 months, suggesting that a below-benchmark duration stance in the U.K. is appropriate. Yet with U.K. growth slowing and leading indicators suggesting more of that is to come, and with still no resolution to the Brexit negotiations with the March 29, 2019 "Brexit Day" looming in the distance, Gilt yields are likely to stay relatively subdued versus global peers. We continue to recommend an overweight stance on Gilts in hedged global bond portfolios (Chart 8). Chart 7U.K. Real Rates Are WAY Below Longer-Run R-Star Chart 8Stay Overweight U.K. Gilts Bottom Line: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Bank of Japan: Zero Pressure On The 0% Target Global bond yields got a bit of a jolt recently from the most unlikely of sources - Japan, the place where bond volatility goes to die. Amid media speculation that the Bank of Japan (BoJ) was considering an upward adjustment to its JGB yield target, the 10-year JGB took several runs at breaching the BoJ's implied pain threshold of 0.10%, resulting in the BoJ intervening with offers of "unlimited" purchases to quell the selloff. Yet at the monetary policy meeting last week, the BoJ only delivered modest changes: The allowable range for the 10-year JGB yield was widened to -0.20% to +0.20% New forward guidance was introduced indicating no rate hikes until at least 2020 A shift in the BoJ's equity ETF purchases to favor ETF's that target a broader index We were not surprised by the outcome, given that there was absolutely no reason why the BoJ should have even considered a change in policy settings. Back in February, we outlined the three things that we believed must ALL occur before the BoJ could plausibly raise its yield target for the 10-year Japanese government bond (JGB).4 Five months later, none of those conditions has been met (Chart 9): 1) The USD/JPY exchange rate must at least get back to the 115-120 range. USD/JPY has struggled to reach even the bottom end of our target range, only getting to an intraday high of 113.17 on July 19th. The starting point for the yen must be weaker than that before the BoJ can deliver any sort of more hawkish policy that would likely send the yen roaring higher. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5%. The extremely tight Japanese labor market (Chart 10) has finally begun to put upward pressure on wage growth, which now sits at 2.2% on a year-over-year basis. There has been no follow through into core inflation, however, which only got as high at 0.5% in March before sliding back to 0.2% in June. Chart 9None Of Our Conditions For A BoJ Hike Have Been Met Chart 10How Does This Job Market Not Produce Inflation? 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries. We judge this by looking at the residual from a fundamental model of the 10-year JGB yield published by the BoJ. The model includes both the 10-year U.S. Treasury yield as the proxy for global yields, and the share of outstanding JGBs owned by the central bank to measure the impact of BoJ buying (Table 1). That model suggests that current JGB yields are only at fair value, and that U.S. Treasury yields have to rise by a lot more (to at least 3.5%) to make the current level of JGB yields look "expensive", thus justifying a higher BoJ yield target (USD/JPY would likely be in the 115-120 range if that happened, as well). Yet despite all these factors arguing against any change in the BoJ's policy settings, the topic was seriously discussed at last week's policy meeting, according to Reuters.5 The renewed weakness of Japanese inflation scuttled any chance that a serious policy change could be delivered. The decision to widen the allowable yield range for the 10-year JGB yield not associated with any signaled change to the 0% yield target. Investors got the hint, and yields have calmed down after the late July turbulence. The BoJ is increasingly backed into a corner with its hyper-easy monetary policy. There is no spare capacity in the economy, with the unemployment rate at a 25-year low of 2.4% and the BoJ estimating that the output gap is closed. Our own Japan Central Bank Monitor is no longer in negative territory, indicating that the next policy move should be a tightening (Chart 11). The BoJ has indeed been "tightening", but only by reducing the pace of its bond buying. BoJ purchases now only matches the pace of new JGB - a far cry from when the BoJ was buying more than all new JGBs issued between 2013 and 2017 (bottom two panels). Table 1JGB Yield Model Chart 11BoJ Has Been Quantitatively Tightening There is a reported disagreement within the BoJ over the impact of the negative interest rate and yield curve control policies on Japanese bank profitability and lending capacity. Yet any sort of rate hike, at either end of the yield curve, would result in a sharp increase in the yen. To have that happen now would harm Japanese exporters' competitiveness at the worst possible time. Economic growth is decelerating in two of Japan's major trading partners, China and South Korea. At the same time, U.S. protectionism risks trade wars that would slow global trade at a time when Japanese export growth, and business confidence, may already be peaking (Chart 12). We continue to recommend an overweight position in Japanese government debt within hedged global government bond portfolios. Admittedly, the idea of overweighting a market where nearly half of all bonds still have a negative yield does not sound like a path to riches. Yet the BoJ stands out as the one major central bank that has virtually no chance at credibly talking about, much less delivering, any sort of monetary tightening with core inflation close to 0%. If non-Japanese yields continue to rise over the next 6-12 months, as we expect, then JGBs will once again be a relative outperformer in a global bond bear market (Chart 13). Chart 12Japan Is Vulnerable To A Global Trade War Chart 13Stay Overweight JGBs In Hedged Global Bond Portfolios Bottom Line: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The r-star discussion can be found on pages 39-43 of the August 2018 BoE Inflation Report, which can be found here https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf 2 For example, the BoJ's estimates of Japan's r-star can be found here, https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e06.pdf, while the Bank of Canada's estimates for Canadian r-star can be found here https://www.bankofcanada.ca/wp-content/uploads/2017/11/boc-review-autumn2017-dorich.pdf 3 The BoE estimates full employment to be around the current unemployment rate of 4.25%, which is well below the OECD's estimate of 5.5% shown in the top panel of Chart 5. 4 Please see BCA Global Fixed Income Strategy Special Report "What Would It Take For The Bank Of Japan To Raise Its Yield Target?" dated February 13, 2018, available at gfis.bcaresearch.com 5 https://www.reuters.com/article/us-japan-economy-boj-policy-insight/bojs-architect-of-shock-and-awe-plots-retreat-from-stimulus-idUSKBN1KR0TA Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Recommended Allocation Risks to equities and credit are now evenly balanced. We downgrade both to neutral. We are worried that desynchronized growth will further push up the dollar, damaging emerging markets, especially since U.S. inflation will remove the Fed "put". The trade war is nowhere near over, and China shows signs of slowing growth. To de-risk, we raise U.S. equities to overweight, cut the euro zone to neutral, and increase our underweight in EM. We move overweight in cash, rather than fixed income because, with inflation still rising, we see U.S. 10-year rates at 3.3% by year-end. We turn more cautious on equity sectors (reducing the pro-cyclicality of our recommendations by raising consumer staples and cutting materials) and suggest less pro-risk tilts for alternative assets, shifting to hedge funds and away from private equity. Overview Lowering Risk Assets To Neutral Since last December we have been advising risk-averse clients, who prioritize capital preservation, to turn cautious, but suggested that professional fund managers who need to maximize quarterly performance stay invested in risk assets. With U.S. equities returning 3% in the first half of the year and junk bonds 0% (versus -1% for U.S. Treasury bonds), that was probably a correct assessment. Now, however, our analysis indicates that the risk/reward trade-off has deteriorated. Although we still do not expect a global recession until 2020, risks to the global equity bull market have increased. The return outlook is asymmetrical: a last-year bull market "melt-up" could give 15-20% upside, but in bear markets over the past 50 years global equities have seen peak-to-trough declines of 25-60% (Table 1). We think it better to turn cautious too early. A key to successful asset allocation is missing the big drawdowns - but getting the timing of these right is a near impossibility. Table 1How Much Stocks Fall In Bear Markets Chart 1Growth Is Becoming More Desynchronized What are the risks we are talking about? Global growth is slowing and becoming less synchronized (Chart 1). Fiscal stimulus and a high level of confidence among businesses are keeping U.S. growth strong, with GDP set to grow by close to 3% this year and S&P 500 earnings by 20%. But the euro zone and Japan have weakened, and these growing divergences are likely to push the dollar up further, which will cause more trouble in emerging markets. EM central banks are reacting either by raising rates to defend their currencies (which will hurt growth) or by staying on hold (which risks significant inflation). With the U.S. on the verge of overheating, the Fed will need to prioritize the fight against inflation. Lead indicators of core inflation suggest it is likely to continue to rise (Chart 2). The FOMC's key projections seem incompatible with each other: it sees GDP growth at 2.7% this year (well above trend), but unemployment barely falling further, bottoming at 3.6% by end-2018 (from 3.8% now) and core PCE inflation peaking at 2.1% (now: 2.0%). A further rise in inflation means that the Fed "put option" will expire: even if there were a global risk-off event, the Fed might not be able to put tightening on hold. It will take only one or two more hikes for Fed policy to be restrictive - something we have previously flagged as a key warning signal (Chart 3). Chart 2U.S. Inflation Could Pick Up Further Chart 3Fed Policy Is Close To Being Restrictive There is no end in sight for the trade war. President Trump is unlikely to back down on imposing further tariffs on China, since the tough stance is proving popular with his support base. On the other hand, President Xi Jinping would lose face by giving in to U.S. demands. BCA's geopolitical strategists warn that we are not at peak pessimism, and do not rule out even a military dimension.1 China is unlikely to roll out stimulus, as it did in 2015. With the authorities focused on structural reform, for example debt deleveraging, the pain threshold for stimulus is higher than in the past. Recent moves such as reductions in banks' reserve requirement have had little impact on effective interest rates (Chart 4). More likely, China might engineer a weakening of the RMB, as it did in 2015. There are signs that it is already doing so (Chart 5). This would exacerbate political tensions. Chart 4China Has Not Eased Monetary Conditions... Chart 5...But It Might Be Depreciating The RMB As we explain in detail in the pages that follow, with risk now two-way, we cut our weighting in global equities to neutral. We are not going underweight since global economic growth remains above trend, and corporate earnings will continue to grow robustly (though no faster than analysts are already forecasting). We see upside risk if the Fed were to allow an overshoot of inflation amid strong growth. If the concerns highlighted above cause a 15% correction in equity markets - triggering the Fed to go on hold - we would be inclined to move back overweight (having in mind a scenario like 1987 or 1998, where a sell-off led to a last-year bull-market rally). More likely, however, we will move underweight at the end of the year, when recession signals, such as an inverted yield curve, appear. We have shifted our detailed recommendations to line up with this de-risking. We move overweight U.S. equities (which are lower beta, and where unhedged returns should benefit from a stronger dollar). We keep our overweight on Japan, since the Bank of Japan remains the last major central bank in fully accommodative mode. We increase our underweight in EM equities. Among sectors, we reduce pro-cyclicality by cutting materials to underweight and raising consumer staples to overweight. We remain underweight fixed income, since inflationary pressures point to the 10-year U.S. Treasury bond yield moving up to 3.3% before the end of this cycle. We remain short duration and continue to prefer inflation-linked securities over nominal bonds. Within fixed income, we cut corporate credit to neutral, in line with our de-risking. Finally, we recommend that investors move into cash rather than bonds, though we understand that, especially for European investors, this may mean accepting a small negative return.2 Still puzzled how markets may pan out over the next 12 months? Then join BCA's annual Conference in Toronto this September, where I will be chairing a panel on asset allocation, featuring two experienced Chief Investment Officers, Erin Browne of UBS Asset Management, and Norman Villamin of Union Bancaire Privée. Garry Evans, Senior Vice President garry@bcaresearch.com What Our Clients Are Asking How To Overweight Cash? Chart 6Sometimes Cas Is The Only Answer BCA's call to start to derisk portfolios includes a new overweight in cash. This is logical since, historically, cash often outperformed both equities and bonds early in a downturn, when growth was starting to falter (bad for equities) but inflation was still rising (bad for bonds) - though this last happened in 1994 (Chart 6, panel 1). Currently, a move to cash is easy for U.S. investors, who can invest in three-month Treasury bills yielding 1.9%, or USD money market funds, some of which offer just over 2%. But it is much harder for investors in the euro area, where three-month German government bills yield -0.55%. Also, in Japan cash yields -0.17% and in Switzerland -0.73%. Some European investors will be tempted to go into U.S. cash. Given our view of dollar appreciation over the next six months, this should pay off. But it clearly is risky, should we be wrong and the dollar decline. As theory predicts, the cost of hedging the U.S. dollar exposure wipes out any advantage (since three-month euro-dollar forwards are 2.7% lower on an annualized basis than EURUSD spot). Some investors will have to put up with a small negative return in nominal terms in order to (largely) protect their capital. More imaginative European fund managers might be able to come up with schemes to get cash-like returns but with a positive return. For example, Danish mortgage bonds yield 1.8% (in Danish krone, which is largely pegged to the euro) with little risk. U.S. mortgage-backed securities offer yields well over 3%, which should give a positive return after hedging costs (and relatively low risk, given the robust state of the U.S. housing market) - panel 3. Carefully-selected global macro hedge funds can give attractive Libor-plus returns.3 We still see attractiveness of catastrophe bonds,4 which have a high yield and no correlation to the economic cycle. How Seriously Should We Take The Risk Of A Trade War? Is this a full-blown trade war? The answer is not yet. However, the risk is rising that the current spat will turn into one. President Trump has escalated tensions further by indicating that a 10% tariff would be placed on $200 billion of Chinese imports, in addition to the 25% tariff on $50 billion of imports announced in March and to be implemented on July 6. Trump's incentive to escalate the conflict is that a tough trade policy plays well with his support base (Chart 7). Ever since the trade issue hit the headlines early this year, his approval ratings have been on the rise. This means that he is unlikely to back down at least until the mid-term elections in November. Xi Jinping is also unlikely, for his own political reasons, to give in to U.S. demands. But China's retaliation will most likely come through non-tariff actions, since its imports from the U.S. total only about $130 billion (compared to $500 billion of Chinese exports to the U.S.). It could look to restrict imports, for example via quotas, or cause extra bottlenecks for U.S. businesses operating in China. Additionally, it could threaten to sell some of its holdings of U.S. Treasuries, or devalue the RMB. As Chart 8 shows, the RMB has already weakened against the dollar this year (though this was mainly due to the dollar's overall strength). There are suggestions that China might adjust the currency basket that it targets for the RMB, for example by adding more Asian currencies, to allow further depreciation against the dollar. Chart 7 Chart 8Sharp Rise In RMB This Year It is hard, then, to see a smooth outcome to this standoff. A further escalation could even have a military dimension, with the U.S. having recently opened a new "embassy" in Taiwan, and sailing navy vessels close to Chinese "islands" in the South China Sea. It is also a complication that President Trump has recently raised tensions with other G7 trading partners, rather than engaging their help in combatting China's perceived unfair trading practices. Is It Time To Buy Chinese A-Shares? In Q2 2018, MSCI China A-shares lost 19% in absolute terms, compared to a 3.5% gain for MSCI U.S. Some investors attribute this performance divergence to trade tension between the U.S. and China, and take the view that the Chinese government may step in to stimulate the economy and support the equity market, similar to what happened in 2015. We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. Given elevated debt levels and excess capacity in some parts of the economy and worries about pollution, however, the bar for a fresh round of stimulus is a lot higher than in the past. With the incremental inclusion of MSCI on-shore A-Shares into the MSCI China investible universe, A-shares are gaining more attention from international investors. However, the A-Share Index is very different from the MSCI China Index. First, the sector compositions are very different, as shown in Chart 9. The MSCI China index is not only dominated by the tech sector (40%), it's also very concentrated, with the top 10 names accounting for 56% of the index, while the top 10 names in the A-shares account for only about 20%. Second, even in the same sectors, the performance of the two indexes has diverged as shown in Chart 10. We see the reason for these divergences being that domestic investors are more concerned about growth in China than foreign investors are. Instead of buying A-Shares, investors should be more cautious on the MSCI China Index, for which we have a neutral view within MSCI EM universe. Chart 9 Chart 10ONE CHINA, TWO DIFFERENT EQUITY INDEXES What Are The Characteristics Of The Private Debt Market? Chart 11Private Debt Market Private debt (Chart 11) raised a record $115 billion through 158 funds in 2017, pushing aggregate AUM from $244 billion in 2007 to $664 billion in 2017. This explosive growth was driven by bank consolidation in the U.S., increased financial sector regulation, and the global search for yield. Private debt has historically enjoyed a higher yield and return, along with fewer defaults, than traditional public-market corporate bonds. Below are some of the key points from our recent Special Report:5 Private debt has returned an average net IRR of 13% from 1989 to 2015. This compares to an annualized total return of 7% and 7.2% for equities and corporate bonds respectively. Investors can diversify their sources of risk and return by giving access to more esoteric exposures such as illiquidity and manager skill. The core risk exposure in private debt comes from idiosyncratic firm-specific sources, which is not the case with publicly traded corporate credit. Investors can gain more tailored exposure to different industries and customized duration horizons. Additionally, private debt was the only group in the private space that did not experience a contraction in AUM during the financial crisis. Direct lending and mezzanine debt are capital preservation strategies that offer more stable returns while minimizing downside. Distressed debt and venture debt are more return-maximizing strategies that offer larger gains, but with a higher probability of losses. In the late stages of an economic cycle, investors should deploy capital defensively through first-lien and other senior secured debt positions. In contrast, a recession would create opportunities for distressed strategies and within deeper parts of the capital structure. Global Economy Overview: Growing divergences are emerging in global growth, with the U.S. producing strong data, but a cyclical slowdown in the euro area and Japan, and the risk of significantly slower growth in China and other emerging markets. This means that monetary policy divergences are also likely to increase, exacerbating the rise in the U.S. dollar and putting further pressure on emerging markets. Eventually, however, tighter financial conditions could start to dampen growth in the U.S. too. U.S.: Data has been very strong for the past few months, with the Fed's two NowCasts pointing to 2.9% and 4.5% QoQ annualized GDP growth in Q2. Small businesses are confident (with the NFIB survey at a near record high), which suggests that the capex recovery is likely to continue. With unemployment at the lowest level since 1969, wages should pick up soon, boosting consumption. But it is possible the data might now start to weaken. The Surprise Index (Chart 12, panel 1) has turned down. And a combination of trade war and a stronger dollar (up 8% in trade-weighted terms since April) might start to dent business and consumer confidence. Chart 12U.S. Growth Remains Strong... Chart 13...While Europe, Japan And EMs Start To Slow Euro Area: Euro area data, by contrast to the U.S., have turned down since the start of the year, with both the PMI and IFO slipping significantly (Chart 13, panel 1). This is most likely because the 6% appreciation of the euro last year has affected export growth, which has slowed to 3.1% YoY, from 8.3% at the start of the year. However, the PMI remains strong (around the same level as the U.S.) and, with a weaker euro since April, growth might pick up late in the year, as long as problems with trade and Italy do not deteriorate. Japan: Japan's growth has also slipped noticeably in recent months (Chart 13, panel 2), perhaps also because of currency strength, though question-marks over Prime Minister Abe's longevity and the slowdown in China may also be having an effect. The rise in inflation towards the Bank of Japan's 2% target has also faltered, with core CPI in April back to 0.3% YoY, though wages have seen a modest pickup to 1.2%. Emerging Markets: China is now showing clear signs of slowing, as the tightened monetary conditions and slower credit growth of the past 12 months have an effect. Fixed-asset investment, retail sales and industrial production all surprised to the downside in May. The authorities have responded to this (and to threat of trade disruptions) by slightly easing monetary policy, though this has not yet fed through to market rates, which have risen as a result of rising defaults. Elsewhere in EM, many central banks have responded to sharp declines in their currencies by raising rates, which is likely to dampen growth. Those, such as Brazil, which refrained from defensive rate hikes, are likely to see an acceleration in inflation Interest rates: The Fed has signaled that it plans to continue to hike once a quarter at least for the next 12 months. It may eventually have to accelerate that pace if core PCE inflation moves decisively above 2%. The ECB, by contrast, announced a "dovish tightening" last month, when it signaled the end of asset purchases in December, but no rate hike "through the summer" of next year. It can do this because euro zone core inflation remains around 1%, with fewer underlying inflationary pressures than in the U.S. The Bank of Japan is set to remain the last major central bank with accommodative policy, since it is unlikely to alter its yield-curve control any time soon. Global Equities Chart 14Neutral Global Equities A Bird In The Hand Is Worth Two In The Bush: After the initial strong recovery from the low in March 2009, global equity earnings have risen by only 20% from Q3 2011, and that rise mostly came after February 2016. In the same period, global equity prices, however, have gained over 80%, largely due to multiple expansion (Chart 14), supported by accommodative monetary and stimulative fiscal policies. Year-to-date, our pro-cyclical equity positioning has played out well with developed markets (DM) outperforming emerging markets (EM) by 8.8%, and cyclical equities outperforming defensives by 2.9%. As the year progresses, however, we are becoming more and more concerned about future prospects given the stage of the cycle, stretched valuations and the elevated profit margin.6 The three macro "policy puts", namely the Fed Put, the China Put and the Draghi Put, are all in jeopardy of disappearing or, at the very least, of weakening, in addition to the risk of rising protectionism. BCA's House View has downgraded global risk assets to neutral.7 Reflecting this change, within global equities we recommend investors to take a more defensive stance by reducing portfolio risk. We remain overweight DM and underweight EM; We upgrade U.S. equities to overweight at the expense of the euro area (see next page); Sector-wise, we suggest to take profits in the pro-cyclical tilts and become more defensive (see page 14). Please see page 21 for the complete portfolio allocation details. U.S. Vs. The Euro Area: Trading Places Chart 15Favor U.S. Vs. Euro Area In line with the BCA House View to reduce exposure in global risk assets, we are downgrading the euro area to neutral in order to fund an upgrade of the U.S. to overweight from neutral, for the following reasons: First, GAA's recommended equity portfolio has always been expressed in USD terms on an unhedged basis. Historically, the relative total return performance of euro area equities vs. the U.S. has been highly correlated with the euro/USD exchange rate. With BCA's House View calling for further strength of the USD versus the euro, we expect euro area total return in USD terms to underperform the U.S. (Chart 15, panel 1). Second, the euro area economy has been weakening vs. the U.S. as seen by the relative performance of PMIs in the two regions; this bodes ill for the euro area's relative profitability (Chart 15, Panel 2). Third, because euro area equities have a much higher beta to global equities than U.S. equities do, shifting towards the U.S. reduces the overall portfolio beta (Chart 15, Panel 3). Last, even though euro area equities are cheaper than the U.S. in absolute term, they have always traded at a discount to the U.S. On a relative basis, this discount is currently fair compared to the historical average. Sector Allocation: Become More Defensive Chart 16Sectors: Turn Defensive Year to date, our pro-cyclical sector positioning has worked very well, especially the underweights in telecoms, consumer staples and utilities, and the overweight of energy. The overweight in healthcare also has worked well, but the overweights in financials and industrials, as well as the underweight of consumer discretionary, have not panned out. Global economic growth has peaked, albeit at a high level. This does not bode well for the profitability of the economically sensitive sectors (industrials, consumer discretionary and materials) relative to the defensive sectors (healthcare, consumer staples and telecoms), as shown in Chart 16, top two panels. In addition, slowing Chinese growth will weigh on the materials sector, and rising tension in global trade will pressure the industrials sector. As such, we are upgrading consumer staples to overweight (from underweight) and telecoms to neutral, and downgrading materials to underweight (from neutral). Oil has gained 16% so far this year, driving energy equities to outperform the global benchmark by 6.2%. Going forward, however, the oil outlook is less certain as OPEC and Russia work to ease production controls, and demand is cloudy. This prompts us to close the overweight in the energy sector to stay on the sideline for now (Chart 16, bottom panel). We also suggest investors to reduce exposure in financials to a benchmark weighting due to our concerns on Europe and also the flattening of yield curves. After all these changes, we are now overweight healthcare and consumer staples while underweight consumer discretionary, utilities and materials. All other sectors are in line with benchmark weightings. Government Bonds Maintain Slight Underweight On Duration. BCA's house view has downgraded global risk assets to neutral and raised cash to overweight, while maintaining an underweight in fixed income.8 This prompts us to downgrade credit to neutral vs. government bonds (see next page). However, we still see rates rising over the next 9-12 months and so our short duration recommendation for the government bonds is unchanged. The U.S. Fed is on track to deliver a 25bps rate hike each quarter given robust business confidence and tight labor markets, and the ECB has announced it will stop new bond buying in its Asset Purchase Program after December this year. As such, bond yields are likely to move higher in both the U.S. and the euro area given the close relationship between 10-year term premium and net issuance (Chart 17). Chart 17Yields Will Rise Further Chart 18Favor Inflation-Linked Bonds Favor Linkers Vs. Nominal Bonds. The latest NFIB survey shows that wage pressure is on the rise, with reports of compensation increases hitting a record high (Chart 18, top panel). BCA's U.S. Bond Strategy still believes that the U.S. TIPS breakeven will rise to 2.4-2.5% around the time that U.S. core PCE inflation exceeds the Fed's 2% target rate (the Fed forecasts 2.1% by end-2018). Compared to the current breakeven level of 2.1%, this means 10-year TIPS has upside of 30-40bps, an important source of return in the low-return fixed income space (Chart 18, panel 2). Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds (Chart 18, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 19Spreads Not Attractive We have favored both investment-grade and high-yield corporates (Chart 19) over government bonds for over two years. But, while monetary and credit conditions remain favorable, we think rising uncertainty and weakening corporate balance sheets in the coming quarters warrant a more cautious stance. We are moving to neutral on corporate credit. In Q1, outstanding U.S. corporate debt grew at an annualized rate of 4.4%, while pre-tax profits (on a national accounts basis) contracted by 5.7%, raising gross leverage from 6.9x to 7.1x. The benign default rates and tight credit spreads associated with robust economic growth are at risk now that leverage growth is soon poised to overtake cash flow growth, challenging companies' debt service capability. Finally, if labor costs accelerate, leverage will continue to rise in 2H18. Since February, our financial conditions index has tightened considerably driven by a combination of falling equity prices and a stronger dollar. As monetary policy shifts to an outright restrictive stance once inflation reaches the Fed's target later in 2018, corporates will suffer. The risk-adjusted returns to high yield (Chart 20) are no longer attractive relative to government bonds. Chart 20Junk Only Attractive If Defaults Stay Low Chart 21Rising Leverage Finally, valuations are expensive. Investment grade spreads have widened by 50bps from the start of the year, but junk spreads are still close to their post-crisis lows. As we are late in the credit cycle, we do not expect further contraction in spreads. For now monetary and credit quality indicators remain stable, but we are booking profits and moving both investment-grade and high-yield corporates to neutral. In the second half of the year, as corporate leverage (Chart 21) starts to deteriorate and monetary policy gets more restrictive, we will look to further review our allocations. Commodities Chart 22Strong Demand But Uncertain Supply In Oil Energy (Overweight): Underlying demand/supply fundamentals (Chart 22, panel 2) will continue to drive prices, as the correlation with the U.S. dollar breaks down. We expect the key OPEC countries to increase production by 800k b/d and over 210k b/d in 2H18 and 1H19 respectively. This will be offset by losses in the rest of OPEC of 530k b/d and 640k b/d in 2H18 and 1H19 respectively. Venezuelan production has dropped from a peak of 2.1m b/d to 1.4m b/d, and we expect it to reach 1.2m b/d by year end and 1.0m b/d by the end of 2019. Additionally, we expect Iranian exports to fall by 200k b/d to the end of 2018, and by another 300k b/d by the end of 1H19 as a result of sanctions. Demand seems to be holding up for now, but is conditional on developments in global trade. BCA's energy team forecasts Brent crude to average $70 in 2H18 and $77 in 2019. Industrial Metals (Neutral): China remains the largest consumer of metals, and so price action will react to underlying economic growth there and to the dynamics of its local metals markets. Additionally, a strengthening dollar will add downward pressure to prices and increase volatility. We expect a physical surplus in copper markets to emerge by year end, given slower demand growth and supply concerns due to restrictions on China's imports of scrap copper. Precious Metals (Neutral): Rising global uncertainties and geopolitical tensions driven by trade wars and divergent monetary policy will continue to keep market volatility high. During periods of equity market downturns, gold will continue to be an attractive hedge. Additionally, as inflationary pressures continue to rise, investors will continue to look for inflation protection in gold. However, rising interest rates and a strengthening dollar could limit price upside. We recommend gold as a safe-haven asset against unexpected volatility and inflation surprises. Currencies Chart 23Dollar Appreciation To Continue King Dollar U.S. Dollar: Following the recent strong economic data out of the U.S., the Fed is likely to maintain its moderately hawkish stance and follow its current dot plan of gradual rate hikes over the course of this year and next. For now the Fed is unlikely to accelerate the pace of hikes: it hinted that it could allow inflation to overshoot its target of 2% on core PCE. We expect the U.S. dollar to appreciate further over the coming months (Chart 23, panel 1). Euro: Disappointments in European economic data, in addition to political uncertainties in Italy, have led to a correction in the EUR/USD (Chart 23, panel 2). The ECB's indication that it will not raise rates through the summer of 2019 added further downward pressure on the currency. In addition, rising tension related to trade war and its impact on European growth is likely to dampen the euro's performance further. We look for EUR/USD to weaken to at least 1.12. JPY: The outlook for the yen is more mixed than for the euro. Japanese data over the past couple of months have been anemic, and interest rate differentials with the U.S. point to a weakening yen (Chart 23, panel 3). Moreover, the BoJ is still concerned with achieving its inflation target and so remains the last major central bank in full accommodative mode. However, escalating global tension is likely to be a positive factor for the JPY as a safe haven currency. It also looks far cheaper relative to PPP than does the euro. We see the yen trading fairly flat to the USD, but appreciating against the euro. EM Currencies: Tighter U.S. financial conditions, rising bond yields, and a strengthening dollar are all disastrous for EM currencies (Chart 23, panel 4). Additionally, the ongoing growth slowdown in China, and in EM as a whole, will add further downside pressures on most EM currencies. Alternatives Chart 24Turn Defensive On Alts Allocations to alternatives continue to rise as investors look for new avenues to preserve capital and generate attractive returns. We are turning more cautious on risk assets across all asset classes on the back of a possible growth slowdown and restrictive monetary policy. With intra-correlations between alternative assets reaching new lows (Chart 24), investors need to be especially careful picking the right category of alt investments. Return Enhancers: We have favored private equity over hedge funds since 1Q16, and this has generated an excess return of 20%. But, given our decision to scale back on risk assets on the back of a possible growth slowdown, we are turning cautious on private equity. Higher private-market multiples, stiff competition for buyouts from large corporates, and an uncertain macro outlook will make deal flow difficult. On the other hand, as volatility makes a comeback and markets move sideways, discretionary and systematic macro funds should fare better. We recommend investors pair back on their private equity allocations and increase hedge funds as we prepare for the next recession. Inflation Hedges: We have favored direct real estate over commodity futures since 1Q16; this position has generated a small loss of 1.4%. Total global commercial real-estate (CRE) loans outstanding have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. CRE prices peaked in late 2016, and are now flat-lining, partly due to the downturn of shopping malls and traditional retail. On the other hand, commodity futures have had a good run on the back of rising energy prices. We recommend investors reduce their real estate allocations, and put on modest positions in commodity futures as an inflation hedge. Volatility Dampeners: We have favored farmland and timberland over structured products since 1Q16, and this has generated an excess return of 6%. As noted in our Special Report,9 of the two, timberland assets tend to have a stronger correlation with growth, whereas farmland demand is relatively inelastic during times of a slowdown. Additionally, farmland returns tend to have lower volatility compared to timberland. Structured products will continue to suffer with rising rates. We recommend investors allocate more to farmland over timberland, and stay underweight structured products. Risks To Our View Chart 25What If China's Imports Weaken Sharply Our neutral view on risk assets implies that we see the upside and downside risks as evenly balanced. Could the macro environment turn out to be worse than we envisage? Clearly, there would be more downside for equities if the risks we highlighted in the Overview (slowing growth, U.S. inflation, trade war, Chinese policy) all come through. China and emerging markets are the key. China's import growth has been trending down for 12 months; could it turn significantly negative, as it did in 2015 (Chart 25)? Emerging markets look sensitive to further rises in U.S. interest rates and the dollar. The most vulnerable currencies have already fallen by up to 20% since the start of the year, but could fall further (Chart 26). We would not over-emphasize these risks, however. If growth were to slow drastically, China would roll out stimulus. Emerging markets are more resilient than they were in the 1990s, thanks to currencies that mostly are floating and generally healthier current account positions (though, note, their foreign-currency debt is bigger). Chart 26EM Currencies Could Fall Further Chart 27Is This An Excuse For The Fed To Be Dovish? On the positive side, the biggest upside risk comes from the Fed slowing the pace of rate hikes even though growth is robust. This might be because U.S. inflation remains subdued (perhaps for structural reasons) - or because the Fed allows an overshoot of inflation, either under political pressure, or because of arguments that its inflation target is "symmetrical" and that it has missed it on the downside ever since the target was introduced in 2012 (Chart 27). This would be likely to weaken the dollar, giving emerging markets a reprieve. It might lead to a 1999-like stock market rally, perhaps led again by tech - specifically, internet - stocks. 1 Please see What Our Clients Are Asking: How Seriously Should We Take The Risk Of A Trade War, on page 7 of this Quarterly for more analysis of this subject. 2 Please see What Our Clients Are Asking: How To Overweight Cash, on page 6 of this Quarterly for some suggestions on how to minimize this. 3 Please see Global Asset Allocation Special Report, "Hedge Funds: Still Worth Investing In?", dated June 16, 2017, available at gaa.bcaresearch.com 4 Please see Global Asset Allocation Special Report, "A Primer On Catastrophe Bonds", dated December 12, 2017, available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Private Debt: An Investment Primer", dated June 6, 2018, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation - Quarterly Portfolio Outlook, dated April 3, 2018, available at gaa.bcaresearch.com 7 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 8 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 9 Please see Global Asset Allocation - Special Report "U.S. Farmland & Timberland: An Investment Primer", dated October 24, 2017, available at gaa.bcaresearch.com GAA Asset Allocation
Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Chart 7U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect 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 nowhere close to dangerous 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. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 20China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Chart 23Trade In Intermediate Goods Dominates This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 27Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Chart 32The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap Chart 37When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Appendix B Chart 1Market Outlook: Bonds Appendix B Chart 2Market Outlook: Equities Appendix B Chart 3Market Outlook: Currencies Appendix B Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades