Labor Market
Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. 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 a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Chart 9MacroQuant Still Positive##BR##On The Stock Market Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Watching The Warning Signals Recommended Allocation Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation
Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.
Highlights The so-called 'Silver Tsunami' of retiring baby boomers will continue to be a drag on aggregate wage growth for some time. We would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. Overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The global inflation mini-cycle will turn down in early 2018. Approaching the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Feature Last week, the Bank of England pointed out that "some of the softness in recent pay outturns had related to the composition of employment, with the number of low-paid jobs growing disproportionately."1 Separately, a recent study by the Federal Reserve Bank of San Francisco described the exact same phenomenon in the United States. "The drag on wage growth reflects changes in workforce composition."2 The San Francisco Fed study highlighted two paradoxes. The first paradox is that for continuously full-time employed workers, wages are actually rising quite strongly. For the continuously employed, pay is growing close to the rate seen at the previous economic peak in 2007 (Chart I-2). Chart of the WeekThe Inflation Mini-Cycle Will Turn Down In Early 2018 Chart I-2Will The Real Wage Inflation Please Stand Up However, the entry of new and returning workers to full-time employment continues to depress aggregate wage growth - because new entrants generally earn less than workers who are leaving full-time employment. This creates the second paradox. Strong job growth can actually pull down average wages in the economy and slow the pace of aggregate wage growth. Solving The Wage Puzzle According to the San Francisco Fed, this 'composition effect' is exceptionally pronounced right now because of the large-scale exit of higher-paid baby boomers from the labour force. This has depressed aggregate wage growth by 2 percentage points, a sizeable effect relative to the normal expected wage gains. Furthermore, with so many of the baby boomer generation still approaching retirement, "the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time." A second very important factor is at play. The current wave of technological progress is having its most disruptive impact on middle-income jobs. As we explained in Why Robots Will Kill Middle Incomes,3 "high-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources." The upshot is that when baby boomers retire, automation and Artificial Intelligence (AI) are replacing many of the jobs that the boomers occupied in high-income and middle-income sectors such as Finance and Manufacturing, rather than opening up these formerly lucrative career paths to new entrants. Therefore, new entrants are flooding into industry sectors which AI cannot yet disrupt but which are traditionally much lower paid with limited prospects for advancement - sectors like Food Services and Drinking Places and Administrative and Support Services (Table I-1). Table I-1Which Sectors Are Creating The Most Jobs? In summary, for the continuously employed, wages are rising healthily. But for aggregate wage growth, the composition effect from retirements and new entrants is an exceptionally strong headwind. What does this mean for overall inflation? The study concludes that as long as the economy can keep its wage bill low by replacing retiring staff with AI and with lower-paid workers, "labour cost pressures for higher price inflation could remain muted for some time." Given that the next wave of AI is just about to hit us, we expect these conditions to hold true in all developed economies for at least the next five years. Solving The U.K. Productivity Puzzle Chart I-3Since The Global Financial Crisis U.K. ##br##Productivity Has Stagnated But the San Francisco Fed study does also carry a warning about a latent inflationary threat. If productivity growth is slowing, "continued increases in unit labour costs could be hiding behind low readings on measures of aggregate wage growth." This seems to be a particular worry in the U.K. Since the global financial crisis, serial disappointments in productivity growth have concerned the Bank of England (Chart I-3). However, the Bank need not worry. We would like to present a very simple explanation for the U.K.'s so-called 'productivity puzzle'. Big clues come from comparing and contrasting the economic recoveries of 1993-2000 with 2009-17. At the very beginning of the two recoveries, productivity growth evolved in the same way. But then it took drastically different paths. Through the late 1990s, productivity growth accelerated, whereas through the 2010s productivity has stagnated. Why? A plausible explanation comes from the mirror-image patterns in self-employment. At the very beginning of the two recoveries, self-employment evolved in the same way. But through the late 1990s self-employment fell by 300,000, whereas through the 2010s self-employment has increased by a million, accounting for 30% of all jobs created (Chart I-4, Chart I-5, Chart I-6, Chart I-7). Furthermore, there is a tell-tale pattern. Whenever self-employment has picked up most sharply - for example, 2011-13 and 2015 - productivity growth has taken a big hit. Chart I-41990s Recovery: ##br##Self-Employment Fell Chart I-52010s Recovery: Self-Employment ##br##Has Risen Sharply Chart I-6Compare And Contrast: ##br##The Pattern of Self-Employment... Chart I-7...And Productivity...##br##Are Mirror-Images What's going on? Contrary to popular belief, the self-employed are not innovative entrepreneurs, who might typically boost productivity. The Office for National Statistics itself has poured cold water on the increased innovation thesis, claiming that "while there has been an increase in the number of people who are self-employed there has been a reduction in the number of employees who work for the self-employed." Given that these new self-employed work for themselves with no employees of their own, the idea that they are innovative entrepreneurs is a long way from the truth. In reality, the new model army of self-employed consists of former employees in sectors like journalism, media and technology who are now freelancing. And this provides a simple explanation for the productivity puzzle. Job creation that is skewed to self-employment depresses productivity growth. The reason is that the army of self-employed have to carry out tasks in which they have no specialism, and in which they are therefore much less productive. For example, a freelance journalist must spend time managing her IT gremlins, accounts, sales pitches, and so on, rather than focussing entirely on her special skill of writing powerful news stories. This makes her much less productive as a freelancer than as an employee. However, this hit to productivity eventually abates in one of two ways: freelancers gradually become more adept at the new tasks they must undertake; or more likely, they switch back to employee jobs in which they are much more productive. Combining the messages from the first two sections, the Bank of England need not fear labour cost pressures for higher price inflation. Furthermore, with Brexit negotiations progressing at a snail's pace, U.K. based companies are getting increasingly nervous about what their future international trading relationships will look like. So we would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. The investment conclusion is to overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The Inflation Mini-Cycle Will Turn Down In Early 2018 Last week, we reviewed our mini-cycle framework for the global economy. To recap, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern with each half-cycle lasting about 8 months. As the current mini-upswing started in May, we are likely more than half way through the mini-upswing - with an expected end around January/February 2018. At which point, the cycle will enter a mini-downswing. The mini-cycle framework is so powerful that it also perfectly explains the mini-cycles in commodity price inflation - specifically, metals - and unsurprisingly, in overall inflation too. To anybody who still doubts the existence of these remarkably regular mini-cycles, the Chart of the Week and Chart I-8 should put the doubts to rest once and for all. Chart I-8Metal Price Inflation Also Exhibits Remarkably Regular Mini-Cycles Make no mistake. The mini-cycle in commodity prices and overall inflation will turn down in early 2018. So as we approach the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From the Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on November 1, 2017. 2 From the SF Fed blog 'The Good News on Wage Growth' August 14. 2017. 3 Please see the European Investment Strategy Special Report 'Why Robots Will Kill Middle Incomes' August 10, 2017 available at eis.bcaresearch.com. Fractal Trading Model* The near 20% rally in Japan's Nikkei 225 since early September has taken its 65-day fractal dimension to its lower bound, suggesting a likelihood of a trend-change. So our recommended trade this week is short Nikkei 225 / long Eurostoxx50 with a profit target / stop loss set at 3%. We now have six open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Chart II-6Indicators To Watch -##br## Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch - ##br##Interest Rate Expectations
Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.