Money/Credit/Debt
Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first week. 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-10 * 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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Highlights Consumer spending is well supported despite weak readings on household purchases in early 2018. The recent rollover in M&A activity does not signal a top in equity markets nor warns that a recession looms. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. Feature Investors began to worry last week about a slowing U.S. economy sending prices of risk assets and Treasury yields lower. The threat of a wider trade spat with China was also a concern, along with the latest round of political intrigue at the White House. Oil fell more than 1% on supply concerns. While the U.S. economic surprise index moved lower since the start of the year, BCA's view is that the U.S. economy is poised to grow well above potential in the first half of the year. Consumer spending is well supported despite weak readings on household purchases in early 2018. The FOMC will provide a new set of economic forecasts and dot plots at this week's meeting. BCA expects the Fed to raise rates this week and three additional times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. According to our U.S. Equity Strategy service's "buy the dip" cycle-on-cycle analysis, a retest of the recent equity lows typically occurs in the first month following the initial shock, suggesting that the S&P 500 is already out of the woods.1 The return of vol may keep a lid on the SPX for a while longer, but our strategy since February 8 is to buy the dips as we do not foresee an end to the business cycle in 2018. Moreover, the recent weakness in M&A activity is not a sign that the bull market is finished. Despite the dip below 2.90% last week, BCA's U.S. Bond Strategy services pegs fair value for the 10-year Treasury yield at 2.96%.2 Assuming a 3% terminal fed funds rate, our U.S. Bond Strategy team expects the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%.3 Too Cold? Chart 1Weak February Retail Sales At Odds##BR##With Strong Consumers Fundamentals The Tax Cut and Jobs Act put extra cash into consumers' pockets and helped to lift consumer confidence to a cycle high. Household net worth is at a record level, the labor market is strong and wage growth is accelerating, albeit modestly at this point in the cycle. Despite the favorable backdrop, consumers are on the sidelines in early 2018 (Chart 1). Moreover, early March's unusually harsh winter weather in the Northeastern U.S. may prolong consumers' malaise for another month. The retail sales control group, which feeds into GDP calculations, rose a scant 0.1% m/m in February. The reading was well below the consensus of a 0.5% m/m gain. Headline retail sales dipped by 0.1%, well short of expectations (+0.4%). Auto sales (-0.9%) declined for the fourth month in a row in February. It is clear that the surge in auto sales in the wake of last fall's hurricanes pulled up demand. The weakness in February's spending was broadly based, with 7 of 13 major retail sales categories showing month-over-month declines. However, the recent weakness in consumer outlay masks the robust activity in the past 12 months. Overall retail sales are up a solid 4.1% from a year ago, while sales in the retail control group rose by 4.3%. In addition, sales are higher in 12 of the 13 main categories in the past year, led by non-store retailers (+10.1%), miscellaneous store retailers (+7.5%), clothing (+4.9%) and building materials (+4.6%). As a result of the tepid consumer spending readings in early 2018, the Atlanta Fed's GDPNow model has projected Q1 real GDP growth of just 1.8%, adjusted downward from 2.5% on March 9 (Chart 2). At the start of this month, the Atlanta Fed pegged Q1 GDP at 3.5%. Accordingly, some investors are concerned that household spending is nearing a peak and a recession may be imminent. We see it differently. BCA's stance is that consumer spending should continue to grow by at least 2% in 2018. U.S. consumer health has improved markedly in the past year, driving BCA's Consumer Health Indicator into positive territory (Chart 3). Higher equity prices, a stout labor market and an acceleration in real incomes are behind the improvement. Consumer spending growth tends to accelerate when the Health Indicator is rising. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least in the next 12 months. Chart 2Q1 GDP Estimates Have Moved Sharply Lower Chart 3The Consumer Is In Good Shape Household net worth in 2017Q4 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q4 (Chart 4). Moreover, the composition of households' balance sheet is less alarming today than at prior peaks, because equities and real estate relative to household income or total assets are more reasonable. Furthermore, debt levels are tamer today than in 2006. Households may be less vulnerable to unexpected shocks (Chart 4 again) in light of their more resilient balance sheets. BCA's view is that financial vulnerabilities from the household sector are well contained. Household borrowing is increasing modestly at an annual pace of 4%, in sharp contrast with a 12% rate in the middle of the first decade of the 2000s. A broad measure of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recessionary readings. Furthermore, liquidity buffers (liquid assets-to-liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 5). Chart 4Household Sector Balance Sheet Composition Chart 5Household Sector Buffers Are Solid Nevertheless, risks may dampen the pace of consumer spending. Debt-to-income ratios have bottomed for the cycle (Chart 5 again) and banks are tightening their lending standards. The result is that consumer delinquency rates are on the upswing, notably in credit cards and autos (Chart 6). Moreover, the personal savings rate cannot sustainably remain around its recovery low of 3.2% (Chart 7, last panel). Chart 6Consumer Loan Metrics Chart 7Key Supports For Consumer##BR##Spending Remain In Place At 2.8%, annual wage compensation growth remains sluggish and far from the 3-4% rate per year that the Fed stated would be consistent with an economy closer to 2% inflation (Chart 7, panel 4). Moreover, households are still unlikely to binge on more debt to smooth out their expenditures as they did in the middle years of the first decade of the 2000s. A further acceleration in consumer spending would occur only alongside steady improvement in the labor market and improving household confidence on future employment and income gains. Bottom Line: Consumers' good mood and healthy balance sheets have not translated into firmer spending growth so far in 2018. Nonetheless, even with below-average consumer spending, the U.S. economy is expanding above the Fed's estimate of potential GDP, the labor market is tightening and inflation is grinding higher. The Fed remains on track to hike rates four times this year. The outlook for the U.S. consumer remains bright because of solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. Consumer headwinds to monitor are households' historically low saving rates, still tepid wage inflation and escalating delinquency rates. Too Hot? U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and in 2007. Some investors are concerned that the recent rollover in deal volume is a signal that a recession or an equity market top is nigh. Deal volume in dollars and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016. Since then, merger activity has moved lower. The decline in corporate combinations accompanied a sizeable rally in equity markets and robust U.S. and global economies. Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. The recent peak in corporate takeovers (July 2017) relative to GDP matched those prior highs, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, last summer's zenith in global or cross-border M&A, a better indicator of market zest than U.S.-only activity, did not eclipse the peaks in 2007. Even at last summer's high, measured against both global GDP and market cap, worldwide corporate combinations remained below their 2015 top and well below their 2007 peak. At just 6.5% in early 2017, the GDP-based metric was significantly under the 2007Q3 pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were boom years for M&A. Moreover, Phase I of the Fed funds rate cycle4 (the Fed is tightening, but policy is still accommodative) supports accelerating M&A activity (Chart 8A). Corporate combinations also climb during Phase II (Fed tightening, but policy is restrictive). However, M&A activity peaked at the end of Phase II in 2000 and 2007 (Chart 8B). BCA's view is that we will remain in Phase I until at least the end of 2018 and that Phase II may not be over until the end of 2019 or later. Chart 8AM&A Activity In Phase I Of The Fed Cycle... Chart 8BM&A Activity In Phase II Of The Fed Cycle... Bottom Line: The recent rollover in M&A activity does not signal a top in equity markets nor warn that a recession looms. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks and M&A) is not out of line with previous economic expansions (Chart 9). Stay overweight stocks versus bonds as the U.S. economic expansions becomes a decade-long phenomenon. Chart 9Comparison Of Corporate Outlays Across Four Economic Expansion Phases Just Right Wage inflation remains in a gradual upward trend, accelerating just enough to nudge up price inflation and prompt the Fed to hike rates four times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. However, the January reading (+2.8 yoy) on average hourly earnings (AHE) stoked fears of the former, while the February reading (+2.6%) raised concerns of the latter. Chart 10 confirms that most measures of labor market slack have returned to normal. Moreover, the latest soundings on the job market from the National Federation of Independent Business suggest that small business owners have the most job openings in at least 18 years (Chart 11, panel 1). In addition, key concerns have shifted to the quality of the job applicants (panel 2) and the cost of labor (panel 3), away from taxes and over-regulation. Chart 10Labor Market Slack##BR##Is Disappearing Chart 11Hiring And Labor Costs A##BR##Key Concern For Small Businesses Those concerns were underscored in the Federal Reserve's January and February Beige books. Table 1 shows industries with labor shortages; in the year ended February, the gain in average hourly earnings in all but 3 of the industries was faster than average. Moreover, in all but 1 of these categories, labor market conditions are now the tightest since before the onset of the 2007-2009 recession. A recent Fed study5 examines the labor shortages in the manufacturing sector in more detail. The Beige Books noted that many businesses are having trouble finding low-skilled (and to a lesser extent, middle-skilled) workers, with a few mentions of the challenges of finding/retaining highly skilled employees, especially in STEM job functions. Chart 12 shows the wage gains for supervisory staff, a proxy for skilled (panel 1) and non-supervisory employees, and an imperfect proxy for low-skilled workers (panel 2). Both metrics are rising, but the skilled worker proxy accelerated more than the low-skilled metric. Moreover, at 3.1%, the latest reading on supervisory employees is nearly double the pace of non-supervisory personnel. The Atlanta Fed's Wage Tracker provides another lens on wage gains by skill level. Chart 13 shows that wage inflation among skilled positions is running well above average. Raises among mid- and low-skilled labor lag far behind. Notably, wages in all three have rolled over since late 2016. Table 1Labor "Shortages" Identified##BR##In The Beige Book Chart 12Supervisory Vs. Production##BR##Wage Inflation Chart 13Wage Inflation##BR##By Skill-Level Chart 14 argues that slightly faster compensation growth is imminent. The top panel shows that more than 80% of U.S. states register unemployment below the Fed's estimate of full employment. In the past, rates over 60% have been associated with wage pressures. The percentage climbed above 60% in January. The bottom panel of Chart 14 demonstrates the relationship between state unemployment rates and wage gains in each state. Chart 1480%+ Of States Have Unemployment Rates Below NAIRU Bottom Line: The labor market is back to normal, but is not overly tight, as shown in Chart 10. Wages and employment costs are in an uptrend, yet firms are still reluctant to give large pay increases to their labor force. That said, against the backdrop of fiscal stimulus, real GDP growth will remain well above potential, which means that the unemployment rate is headed to 3½% or even below. At some point, the labor market will overheat. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Reflective Or Restrictive", published March 12, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "From Headwinds To Tailwinds", published March 6, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Two-Stage Bear Market In Bonds", published February 20, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Lingering In The Policy Sweet Spot," September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," December 23, 2013. Both available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm
Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: Fed Governor Lael Brainard stated last week that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. Labor Market: The economy continues to add jobs at a rapid pace, but there is some debate about whether the unemployment rate accurately reflects the amount of slack in the labor market. We find that even using the broadest measures of labor market slack, we should expect to see wages accelerate in the coming months. Credit Cycle: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Feature Chart 1Fed's Current Projections Are Priced In The cyclical bond bear market is at a critical juncture. The yield curve has now largely priced-in the Fed's median fed funds rate projections (Chart 1), and this raises the possibility that the bear market could stall unless the Fed starts to signal a more aggressive path for hikes. With that in mind, last week's speech by Fed Governor Lael Brainard caught our attention.1 As the most dovish member of the Board of Governors, Governor Brainard's speeches are important bellwethers of inflection points in monetary policy. This is particularly true when the speeches convey a more hawkish tone, as was the case last week. Governor Brainard's shift in tone signals that the Fed is poised to adopt a somewhat more aggressive tightening bias. This will likely lead to upward revisions to its interest rate projections and give the green light for the cyclical bond bear market to continue. Brainard On Growth Comparatively weak economic growth outside of the U.S. has been a perennial concern for Governor Brainard, and indeed a key theme in this publication.2 But last week she acknowledged that this dynamic has shifted: Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand. [...] The upward revisions to the foreign economic outlook are also pulling forward expectations of monetary policy tightening abroad and contributing to an appreciation of foreign currencies and increases in U.S. import prices. By contrast, foreign currencies weakened in the earlier period, pushing the dollar higher and U.S. import prices lower. Chart 2 shows the dramatic shift that has occurred since mid-2016. The Global Manufacturing PMI has soared, and all but one of the 36 countries with available data now have PMIs above the 50 boom/bust line. As a consequence, the U.S. dollar has depreciated and import prices have surged. A more broadly-based global recovery is bearish for U.S. bonds. With less drag from a stronger U.S. dollar, interest rates must rise further to achieve the same amount of monetary tightening. Although we would still characterize the global economic recovery as highly synchronized, we recently flagged some preliminary signals that suggest the breadth of global growth might be deteriorating.3 Specifically, we observe that leading indicators of Chinese economic activity have rolled over, and the outperformance of emerging market currency carry trades has moderated (Chart 2, bottom panel). We will closely monitor both of these indicators during the next few months to see if the weakness persists, or if it starts to bleed into broader global growth aggregates. While the more optimistic assessment of global growth was the starkest change between last week's speech and Governor Brainard's earlier missives, she also noted reasons for optimism on the domestic front. Nonresidential investment is hooking up, and leading indicators point to further gains (Chart 3, panel 1). Financial conditions remain accommodative despite persistent Fed tightening. This differs from the mid-2014 to mid-2016 period when financial conditions tightened even though monetary policy was more accommodative (Chart 3, panel 2). Most importantly, the economy is poised to receive a huge dose of fiscal stimulus during the next two years in the form of a $1.5 trillion tax cut and a $300 billion increase in federal spending (Chart 3, bottom panel). Even our simple tracking estimate for U.S. GDP suggests that growth is shifting into a higher gear. Aggregate hours worked are growing at an annual pace of 2.2%. When coupled with a conservative estimate of 0.8% for productivity growth - the average since 2012 - that translates into real GDP growth of 3%, well above the average pace of 2.2% we've seen since 2010 (Chart 4). With growth that strong we will almost certainly see further tightening of the labor market in 2018. Chart 2Synchronized Growth Is Bond Bearish Chart 3Domestic Tailwinds Chart 4U.S. GDP Tracking At 3% Brainard On The Labor Market A key question for policymakers is how much slack remains in the labor market. If the Fed views the labor market as at full employment, then it necessarily expects inflation to accelerate and should be prepared to tighten policy. Conversely, an economy with significant labor market slack is not expected to generate inflation. Officially, the Fed's most recent Monetary Policy Report to Congress describes the labor market as "near or a little beyond full employment",4 and in last week's speech Governor Brainard gave an excellent summary of the risks surrounding that assessment. First, she noted that "if the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s" (Chart 5). With growth set to accelerate, we view this as a very likely outcome. In fact, we calculate that, assuming a flat labor force participation rate, the U.S. economy needs to add only 123k jobs each month to keep the unemployment rate under downward pressure. The economy has added an average of 190k jobs per month during the past year, and added a shocking 313k in February (Chart 6). We anticipate it will be some time before job growth falls below the 123k threshold. Chart 5How Much Slack? Chart 6Employment Growth However, it is possible that the unemployment rate is masking some hidden slack in the labor market. Governor Brainard noted that "the employment-to-population ratio for prime-age workers remains more than 1 percentage point below its pre-crisis level" (Chart 5, panel 2). "If substantially more workers could be drawn into the labor force, it would be possible for the labor market to firm notably further without generating imbalances." Chart 7Wage Growth Set To Accelerate In other words, if the labor force participation rate increases, then the unemployment rate could level-off even if job growth remains robust. This would keep a lid on inflation for longer than would be the case otherwise. In our view it will be very difficult for the participation rate to rise meaningfully on a cyclical horizon. As Governor Brainard noted in her speech: "declining labor force participation among prime-age workers predates the crisis" (Chart 5, bottom panel). Added to that, now nine years into the economic recovery, it is questionable whether workers that have been out of the labor force for so long are even able to be drawn back in. Our sense is that the unemployment rate will decline further in the coming months, and it will not be long before that translates into upward pressure on wages. It is important to note that whether we use the unemployment rate or the prime-age employment-to-population ratio as our preferred measure of labor market slack, we are very close to levels that have coincided with exponential wage gains in past cycles (Chart 7). Brainard On Inflation As discussed in our report from two weeks ago, our view is that the headwinds that had been working against inflation are set to fade this year.5 While Governor Brainard agrees that "transitory factors no doubt played a role in last year's step-down in core PCE inflation," she remains concerned that inflation's underlying trend may have softened. Brainard's concern relates to various measures of inflation expectations that are still below levels that prevailed prior to the financial crisis (Chart 8). Without expectations adjusting higher it is doubtful whether inflation can sustainably return to the Fed's 2% target. We share this concern, but note that the cost of inflation protection priced into bond yields has surged in recent months. Survey measures take longer to adjust than market prices, but we anticipate that these measures will also rise as inflation recovers in 2018. The further that measures of inflation expectations (both market-based and survey-based) recover, the more Brainard's concerns about a decline in inflation's underlying trend will fade into the background. Bottom Line: Governor Brainard correctly observed that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. How Sustainable Is Corporate Profit Growth? We've been growing more cautious on the outlook for credit spreads during the past few months, principally because the shift toward a less accommodative monetary policy removes an important support for the corporate bond trade. We view the Fed as getting even more hawkish once inflation expectations are re-anchored around pre-crisis levels, and as such we stand ready to reduce exposure to corporate bonds once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5% (Chart 8, panels 1 & 2). At the time of publication the 10-year TIPS breakeven inflation rate was 2.12% and the 5-year/5-year forward rate was 2.14%. But this is only one piece of the puzzle. For a true bear market in corporate bonds to set in we also need to see rising leverage and mounting defaults. At least for now that is not happening. Our measure of gross leverage for the nonfinancial corporate sector - calculated as total debt divided by EBITD - has flattened off during the past year, and the 12-month trailing default rate is in a steady decline (Chart 9). Chart 8The Re-Anchoring Of Inflation Expectations Chart 9Wider Spreads Need Rising Leverage Chart 9 shows that periods of sustained corporate spread widening almost always coincide with rising gross leverage. Or put differently, for corporate spreads to widen we need to see corporate debt growth consistently exceed profit growth (Chart 9, panel 2). At first blush it is not obvious that profit growth will weaken any time soon. Leading indicators such as total business sales less inventories and the ISM manufacturing index point to a favorable profit outlook (Chart 10). Profit growth should also continue to benefit from dollar weakness for at least the next few months (Chart 10, bottom panel). But there is one leading profit indicator that is starting to flash red. A simple profit margin proxy created by taking the difference between the nonfarm business sector's implicit price deflator and its unit labor costs turned negative in Q4. Chart 11 shows that, although this indicator can be volatile, sustained negative readings almost always foreshadow periods of falling profit growth and corporate bond underperformance. Chart 10Rising Leverage Needs Weaker Profit Growth Chart 11Watch Unit Labor Costs In 2018 The Q4 weakness was driven by a big jump in unit labor costs, and with labor markets as tight as they are this is certainly a trend we see continuing. Unless corporate selling prices can keep pace we will see profit growth sustainably fall below debt growth this year, and this will lead to corporate bond underperformance. Bottom Line: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180306a.htm 2 Please see Theme 3 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017" dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights We are shifting our U.S. recession call from late-2019 to 2020. A cheap dollar and fiscal support will give the Fed more scope to raise rates before monetary policy moves into restrictive territory. The fiscal impulse will fall sharply in 2020. By then, financial conditions will be tighter and economic imbalances will be more pronounced. As is usually the case, a downturn in the U.S. will infect the rest of the world. Emerging markets with large current account deficits and high debt levels are most vulnerable. A cyclical overweight to global equities is still appropriate, but long-term investors should begin to scale back risk exposure. Feature Records Are Meant To Be Broken The NBER Business Cycle Dating Committee, which contrary to popular belief does not serve as a matchmaking service for lonely-heart economists, estimates that the current economic expansion is going on nine years. If it makes it to July 2019, it will be the longest in history (Chart 1). Considering that records begin in 1854 - encompassing 33 business cycles - that will be an impressive achievement. Chart 1Nine Years And Still Going Strong There is an old adage that says "Expansions do not die of old age. They are murdered by the Fed." A year or so ago, it looked like the Fed would pull the trigger sometime in 2019. Now, however, it looks more likely that the deed will be committed in 2020. Two things have changed since the start of last year. First, the real trade-weighted dollar has fallen by 8%. According to the Fed's SIGMA macroeconomic model, this should boost growth by about 0.3% over the next two years. Chart 2U.S. Fiscal Policy Has Become##BR##Much More Stimulative Second, U.S. fiscal policy has become much more stimulative, a point very much in keeping with our Geopolitical Strategy team's long-standing view that age of austerity is giving way to a new age of populism.1 My colleague Mark McClellan estimates that the U.S. fiscal impulse will reach 0.8% of GDP in 2018 and 1.3% of GDP in 2019, up from -0.4% and 0.3%, respectively, in the IMF's October 2017 projections (Chart 2). Mark's calculations incorporate the CBO's assessment of the tax cuts, the recent Senate deal to raise the caps on defense and nondefense expenditures, and $45 billion in hurricane relief. He assumes some delay between when the bill is passed and when the spending takes place. According to the Congressional Budget Office, a little more than half of the expenditures in the 2013 and 2015 spending bills occurred in the same year the funding was authorized. These fiscal measures will cause the federal budget deficit to swell by about 2.3 percentage points to 5.6% of GDP in FY2019. Even that may be an understatement, as this does not include any additional infrastructure spending nor the possible restoration of "earmarks"- the widely criticized practice that allows members of Congress to add appropriations to unrelated bills to fund what often turn out to be politically motivated projects in their districts - which could add a further $25 billion in annual spending. Meanwhile, federal government revenue is coming in below target, which the Office of Management and Budget (OMB) has attributed to lower-than-expected taxable income from pass-through businesses and capital gains realizations. This problem could worsen over the next few years as creative accountants find new loopholes to exploit in the recently passed tax bill. Too Much, Too Late All this stimulus is arriving when the economy least needs it. The unemployment rate currently stands at 4.1%, 0.5 points below the level the Fed regards as consistent with full employment. It has been stuck at that number for four straight months, largely because job growth in the Household survey (which the unemployment rate is based on) has lagged the Establishment survey by a considerable margin. Given the underlying strength in GDP growth, it is likely the job gains in the Household survey will rebound strongly over the course of 2018, taking the unemployment rate down to 3.5% by year-end, well below the Fed's end-2018 projection of 3.9%. A lower-than-projected unemployment rate will permit the Fed to raise rates four times this year, one more hike than currently implied by the dots. The Fed will probably also hike rates three or four times next year. Yet, even those additional rate hikes will not come close to offsetting all the fiscal stimulus coming down the pike. In the absence of a sustained increase in productivity or labor force growth - neither of which appear forthcoming - the economy will continue to overheat. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). The Fed knows this perfectly well, but has chosen to let the economy run hot for fear that a premature tightening will sow the seeds for a deflationary spiral. Chart 3Inflation Is A Lagging Indicator By the time the next recession rolls around, inflation will be higher and financial and economic imbalances will be greater. The fiscal impulse will also fall back towards zero in 2020 as the budget deficit stabilizes at an elevated level. It is the change in the budget balance that is correlated with GDP growth. If output is already being constrained by a lack of spare capacity going into late-2019, the subsequent decline in the fiscal impulse in 2020 could push growth below trend, leading to rising unemployment. And, as we have often noted, once unemployment starts rising, it keeps rising. 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 that was not associated with a recession (Chart 4). Chart 4Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle A recent IMF report highlighted that changes in U.S. financial conditions strongly influence growth abroad.2 As the U.S. falls into a recession, equity prices will tumble and credit spreads will widen. Financial conditions will tighten, transmitting the downturn to the rest of the world. Emerging markets with large current account deficits and high debt levels will be the most vulnerable. The only saving grace is that interest rates will be higher in 2020 than they would have been if the recession had begun in 2019. This will give the Fed a bit more scope to ease monetary policy again. As discussed last week, this will likely set the stage for a stagflationary episode following the recession.3 For Now, Leading Indicators Look A-Okay While our baseline view is that the next recession will occur in 2020, this is more of an educated guess than a firm prediction. Many things, including an overly aggressive Fed, a sharp appreciation in the dollar, and a variety of political shocks, could cause the recession to occur sooner than anticipated. As such, we continue to watch a wide swathe of data to help guide our investment recommendations. The good news is that right now, none of our favorite leading economic indicators such as the level of ISM manufacturing new orders minus inventories, capital goods orders, initial unemployment claims, and building permits are flashing red (Chart 5). Many of these indicators appear in The Conference Board's LEI, which is still rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator (Chart 6). We are still far from that point. Chart 5U.S. Leading Indicators Looking A-OKAY Chart 6U.S. LEI Is Not Flashing Red The same goes for leading financial variables such as credit spreads and the yield curve. The yield curve has inverted in the lead-up to every recession over the past 50 years (Chart 7). The fact that the 10-year/3-month slope has steepened by 30 basis points since the start of the year gives us some comfort that the next recession is still some time away. Chart 7An Inverted Yield Curve Has Often Been A Harbinger Of A Recession Keep An Eye On Credit Credit spreads remained well contained during the recent bout of market turbulence but we continue to watch them closely. Credit typically starts to underperform before equities do, which makes it a good leading indicator for the stock market. This is likely to be especially the case over the next two years. If there is one area where financial imbalances have accumulated to worrying levels, it is in the corporate debt arena. This month's issue of the Bank Credit Analyst estimates that the interest coverage ratio for U.S. companies would drop from 4 to 2½ if interest rates were to increase by 100 basis points across the corporate curve.4 This would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 8). Consumer staples, tech, and health care would be the most affected. Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (I) Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (II) We currently maintain an overweight to equities and spread product but expect to move to neutral later this year and to underweight sometime in 2019. Long-term investors should consider paring back exposure to both asset classes already, given that valuations have become stretched. The Dollar And The Return Of "Twin Deficits" Bigger budget deficits will drain national savings. Since the current account balance is simply the difference between what a country saves and what it invests, the U.S. current account deficit is likely to increase. How the emergence of these twin deficits will affect the dollar is a tough call. Historically, there is no clear relationship between the sum of the fiscal and current account balance and the value of the trade-weighted dollar (Chart 9). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a decline in the household saving rate from the booming housing market. Much depends on what happens to real interest rates. If investors come to believe that persistently large budget deficits will lead to higher inflation, long-term real yields could decline, pushing the dollar lower. In contrast, if investors conclude that the Fed will raise rates by enough to keep inflation from spiraling upwards, real yields could rise. U.S. real yields have gone up across all maturities since the start of the year. As a result, real rate differentials have widened between the U.S. and its developed market peers (Chart 10). However, some of the increase in U.S. real rates has been due to a rising term premium, with the rest reflecting an upward revision to the expected path of policy rates. The latter is good for the dollar. The former is not, because it means that investors are starting to worry about the ability of the market to absorb the increasing supply of Treasurys. Meanwhile, rising interest rates threaten to put further pressure on the U.S. current account deficit. The U.S. net international investment position has deteriorated from -10% of GDP to -40% of GDP since 2007 (Chart 11). The U.S. owes the rest of the world about 68% of GDP in debt - almost all of which is denominated in dollars - but holds only 23% of GDP in foreign debt. Thus, a synchronized increase in global bond yields would cause U.S. net interest payments to rise. If yields in the U.S. increase more than elsewhere, net payments would rise even more. Chart 9Twin Deficits And The Dollar:##BR##No Clear-Cut Relationship Chart 10Real Rate Differentials Have##BR##Widened Between The U.S. And Its DM Peers Chart 11Deterioration In U.S. Net##BR##International Investment Position America's status as a major net external debtor could also constrain the extent to which the dollar appreciates. If the greenback were to strengthen, the dollar value of U.S. external assets would decline, as would the dollar value of interest or dividend payments that the U.S. receives from abroad. This would result in a deterioration in the current account balance and in a worsening in the U.S. net international investment position. Some Positives For The Greenback While the discussion above is bearish for the dollar, it needs to be put into some context. The U.S. current account deficit stands at 2.3% of GDP, down from almost 6% of GDP in 2006 (Chart 12). Much of the improvement in the U.S. balance of payments can be traced back to the plunge of almost 70% in net oil imports, a development that is likely to be permanent given the shale boom. Furthermore, the U.S. trade balance should benefit over the coming quarters from the lagged effects of a weaker dollar. And while we estimate that the primary income balance will deteriorate by about 0.6% of GDP over the next two years, it should still remain in positive territory and above the levels from a decade ago (Chart 13). Chart 12U.S. Balance Of Payments:##BR##Improvement Due To Sinking Oil Imports Chart 13Primary Income Balance Will Decline,##BR##But Will Remain In Positive Territory On the fiscal side, the projected rise in U.S. government debt levels at a time when the economy is booming is concerning. Nevertheless, the U.S. debt profile still compares favorably to countries such as Japan and Italy, two economies with worse growth prospects than the U.S. Italian 30-year bond yields are actually lower than in the United States. If one of the two countries is going to have a debt crisis over the next decade, our guess is that it will be Italy and not the U.S. A Cresting In Global Growth Could Help The Dollar Our preferred explanation for why the dollar began to weaken in 2017 focuses on the role of global growth as well as on technical factors. Chart 14USD Is A Momentum Winner Strong global growth - especially when concentrated outside the U.S., as was the case last year - tends to hurt the dollar. There are a number of reasons for this. First, a robust global economy pushes up natural resource prices, which boosts the terms of trade for commodity-exporting economies. Second, manufacturing represents a smaller share of the U.S. economy than it does in most other countries. Since manufacturing activity is quite cyclically-sensitive, faster global growth benefits economies such as Germany, Sweden, Japan, China, and Korea more than the U.S. Third, stronger global growth tends to boost risk appetites. This has translated into large inflows into EM funds and peripheral European debt markets. The latter have also seen an ebbing of political risk, which has translated into sharply lower sovereign spreads. The acceleration in global growth came at a time when long dollar positions had reached elevated levels. As those positions were unwound, the dollar began to tumble. At that point, the strong upward momentum that fueled the dollar rally following the U.S. presidential election was replaced by downward momentum. The U.S. dollar is one of the most momentum-driven currencies out there (Chart 14). Weakness led to even more weakness. It is impossible to know when the dollar's downward momentum will exhaust itself. What can be said is that speculative positioning has become increasingly dollar bearish. This raises the odds of a short-covering dollar rally (Chart 15). Chart 15Speculative Positioning Has Gotten Increasingly Dollar Bearish Perhaps more importantly, global growth may be peaking. China's economy has slowed, as gauged by the Li Keqiang index, which combines electricity production, freight traffic, and bank lending (Chart 16). Growth in Europe and Japan has also likely reached top velocity. U.S. financial conditions have eased sharply relative to the rest of the world (Chart 17). This, in conjunction with an easier U.S. fiscal policy, suggests that the composition of global growth will shift back towards the U.S. over the coming months. If this were to happen, the dollar could recoup some its losses. Chart 16Chinese Economy##BR##Has Slowed Chart 17U.S. Financial Conditions Have##BR##Eased Sharply Relative To ROW Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016. 2 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, April 2017. 3 Please see Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. Available at bca.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The combined U.S. current account and fiscal deficits are set to rise as Trump's profligacy and higher interest rates kick in. In and of itself, this does not spell doom for the dollar. The Fed's response to the twin deficit is what will ultimately set the path for the greenback. Stimulus hitting an economy at full employment raises the likelihood that the Fed will not stand idly by. The dollar's momentum is not deteriorating anymore, global growth could hit a soft patch, and U.S. hedged yields might regain some composure versus European hedged yields. These factors are likely to precipitate a dollar rebound. The durability of this rebound remains an unknown. An opportunity to go short EUR/SEK has emerged. Feature When it comes to the U.S. dollar, the story of the day has become the twin deficits. It is now presented as the key factor that will drag the dollar lower over the course of the cycle. We do agree there are plenty of reasons to be concerned with the long-term outlook for the dollar. However, we remain unconvinced whether the twin deficits really are the much-vaunted "boogey man" that will haunt the greenback. In fact, we would argue that while they are a handicap for the dollar, the role of the Federal Reserve, global growth and hedging costs take precedence over the evil twins. The Twin Deficit Will Widen We take no offence with the assertion that the twin deficits are set to increase. According to the work of Mark McClellan, who writes The Bank Credit Analyst, the U.S. fiscal deficit is set to increase to 5.5% of GDP over the course of the next two years. U.S. President Donald Trump's tax cuts and the recent spending agreement will undeniably contribute to this.1 The current account deficit is also set to widen. Chart I-1 shows our estimate for the path of the current account. We anticipate it to move to -3.4% of GDP by late 2018 or early 2019. This is a noteworthy deterioration, but one that only brings the U.S. current account to a level last experienced in 2009. One contributor is obviously the trade balance. The Bank Credit Analyst estimates that the impact of the combined fiscal measures announced will reach 0.3% of GDP in 2018. The biggest source of deterioration will not come from trade: it will come from a fall in the net primary income balance of the U.S., which currently stands at 1.1% of GDP. Essentially, higher interest rates in the U.S. means that foreigners will receive greater income from the U.S. Based on the current level of the median long-term interest rate forecasts by the FOMC's participants, my colleague Ryan Swift estimates that a move in 10-year Treasury yields to 3.5% is likely by year end.2 Based on our estimate, this will push down the primary income balance to 0.4% of GDP. It is important to acknowledge that this forecast for the current account is likely to prove to be a worst-case scenario. To begin with, the trade balance could continue to be buffeted by the fact that U.S. energy production keeps expanding, which is slowly but surely moving the U.S. toward a positive energy trade balance (Chart I-2). Moreover, periods of weakness in the USD have been followed by improvements in the U.S. primary income balance. This is because while payments made by the U.S. to foreigners are mostly in the form of interest, 55% of U.S. income receipts are earnings on FDIs. If we add dividends received on foreign equity holdings, this share rises to 80% of U.S. gross primary income. Thus, if the dollar weakens, U.S. receipts benefit from a translation effect as corporations convert their foreign earnings back into U.S. dollars at more beneficial exchange rates. Chart I-1Higher U.S. Rates ##br##Will Hurt The Current Account Chart I-2U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance But do twin deficits even matter? We would argue, it depends. Bottom Line: The U.S. twin deficits are set to increase. The U.S. fiscal deficit will move to 5.5% of GDP and the current account to -3.4% of GDP as interest owed to foreigners is set to increase. Twin Deficit, So What? It is one thing to anticipate a widening of the twin deficits, but does history suggest that twin deficits have an impact on the dollar? Here, the empirical evidence is rather mixed. As Chart I-3 illustrates, there has been no obvious link between twin deficits and the dollar. In fact, Arthur Budaghyan highlighted in BCA's Emerging Market Strategy service the following phases:3 1970s: no discernable relationship; First half of the 1980s: Substantial widening of twin deficits, but a massive dollar bull market materialized; 1985 to 1993: no reliable relationship between twin deficits and the dollar; 1994 to 2001: The dollar did rally as twin deficits narrowed on the back of the fiscal balance moving from roughly -4% of GDP to 2% of GDP; 2001 to 2011: dollar weakened as twin deficits grew deeper; 2011 to 2016: When twin deficits narrowed considerably, the dollar was stable, but when they stopped improving, the dollar rallied 25%. Chart I-3In My Time Of Dying? Let us focus on the growing twin deficits episodes. As it turns out, the missing link between twin deficits and the dollar is Fed policy. A widening in twin deficits is normally associated with a strong economy. Profligate government spending can boost domestic demand, and because imports have a high elasticity to domestic demand, a widening current account also tends to come alongside robust growth. The Volcker Fed played a high-wire act from 1979 to 1982, plunging the U.S. into a vicious double-dip recession in order to bring realized and expected inflation back to earth after the 1970s. Volcker was not about to let former President Ronald Reagan's stimulus boost growth to the point of lifting inflation expectations again, undoing all the Fed's previous good work. He elected to increase real rates sharply, which was the key factor behind the dollar's strength. The 2001 to 2011 experience needs to be broken down in parts. From 2001 to 2003, the twin deficits were expanding thanks to former President George Bush's wars and tax cuts. Yet the Fed did not play the same counterweight as it did in the mid-1980s. Instead, it kept cutting rates all the way until 2003 as then-Chairman Alan Greenspan was worried about deflation. U.S. real rates did not experience the necessary lift required to fight the negative impact of the twin deficits on the dollar. From 2003 to 2007, the twin deficits were in fact narrowing, real rates were trendless and the dollar was experiencing mild depreciation. During that time frame, global growth was extremely robust, China was growing at a double-digit pace and EM economies were booming. Money was flowing toward these destinations. From 2007 to mid-2008, while the twin deficits continued to narrow, the dollar plunged. The sharp fall in real rates as the Fed engaged in aggressive rate cutting explains this apparent inconsistency. From the second half of 2008 to 2009, the dollar surged, despite a further widening of the twin deficits. Real rates rebounded as inflation expectations melted, and risk aversion prompted investors to seek the safety of the global reserve asset and the global reserve currency - Treasurys and the greenback, respectively. From 2009 to the middle of 2011, the twin deficits stabilized, real rates stabilized, and the dollar stabilized as well, but nonetheless experienced wild gyrations as the global economy kept experiencing aftershocks from the great financial crisis. Neither the twin deficits nor real rates were offering a clear path forward, thus the dollar was also mixed. Bottom Line: A close look at various episodes of twin deficits in the U.S. pushes us toward one conclusion: if twin deficits are expanding but the Fed is trying to tighten policy and real rates are rising, the dollar ignores the twin deficits and, in fact, manages to rise. If, however, the twin deficits expand, and real rates do not experience enough upside to counterbalance this development, the dollar weakens. This means one thing for the coming years: Forecasting twin deficits is not sufficient to predict a dollar bear market. Instead, we also need a view on the Fed and the outlook for real rates. So Where Will The Dollar Go In 2018? We expect there could be some upward pressure on the Fed's dots as the year progresses. The reason is rather straightforward. The U.S. economy will receive a very large shot in the arm this year and next. Mark's calculations show that the fiscal thrust in 2018 and 2019 will morph from -0.4% of GDP to 0.8% of GDP, and from 0.3% of GDP to 1.3% of GDP, respectively (Chart I-4). While currently the fiscal thrust is expected to become a large negative in 2020, that year is an election year. There is a non-trivial probability that the fiscal cliff anticipated that year may in fact be postponed: it is not in the interest of the Republicans or Democrats to be blamed for a slowing economy in a year where Americans are hitting the voting booths! This stimulus is not happening in a vacuum either: it is materializing in an environment where the labor market seems to be at full employment, where capacity utilization is tight, and where financial conditions remain easy (Chart I-5). Stimulating when the economy is at full capacity is likely to lift prices more than it will boost real economic activity. The Fed is fully aware of this risk. Chart I-4Much Stimulus ##br##In The Pipeline Chart I-5Could Fiscal Stimulus Be Inflationary With This Backdrop?##br## We Think So However, it remains possible that the Fed will err on the side of caution and wait until the impact of the stimulus measures on the economy become more evident before sending a more hawkish message to the markets. Chart I-6Twin Deficits Narratives ##br##Look Like Ex-Post Explanations If the Fed elects to be proactive and adjusts its message regarding the future path of policy before the impact of the stimulus becomes evident, the dollar could rise as it would put upward pressure on U.S. real rates. If, however, the Fed elects to be reactive and wait until the economy responds to the stimulus package with higher wage growth and inflation, then the dollar could weaken as real rates experience little upside and the twin deficits exact their toll. BCA is currently conducting research to assess which path is more likely. In the meanwhile, there other factors to consider. First, as we highlighted three weeks ago, since 2011, spikes in the number of mentions of the twin deficits in media have historically been associated with temporary rebounds in the dollar following periods of USD weakness (Chart I-6).4 The twin deficits seem to come to the forefront of investors' minds as an ex-post explanation for previous weak-dollar periods. Second, our dollar capitulation index is not only at oversold levels, but the indicator has formed a positive divergence with the trade-weighted dollar's exchange rate (Chart I-7). Technically, this increases the probability of a meaningful rebound in the USD. Chart I-7A Positive Technical Development For The Greenback Third, global growth is showing signs of weakening. We have already highlighted that rollovers in the performance of EM carry trades such as the one we have been experiencing for a few months now have been very reliable leading indicators of activity slowdowns over the past 20 years.5 Korea exports are also ebbing. As Chart I-8 illustrates, when Korean exports weaken, this tends to be associated with weakness in highly pro-cyclical financial variables like EM equities, EM bonds, AUD/USD or AUD/JPY. When a slowdown in global growth materializes, especially when it does so as the U.S. economy is set to accelerate, it tends to be associated with a stronger dollar. Fourth, the super-charged strength in the euro versus the USD since the second quarter of 2017 happened as European hedged yields overtook U.S. hedged yields. Chart I-9 takes the example of a Japan-based investor. We pick Japan as an illustration because Japan is the largest creditor nation in the world, and extra-low domestic yields, Japanese investors continue to exhibit heightened yield-seeking behaviors. When the gap between European bond yields hedged into yen and U.S. bond yields hedged into yen became more negative, the euro was depreciating. Once this gap started to narrow, the euro stabilized. Once European bond yields hedged into yen became greater than U.S. bond yields hedged into yen, the euro took off. Chart I-8Growth Sensitive Assets May Be At Risk Chart I-9Are Hedged Yields The Culprit Behind The Dollar's Weakness? We expect these gaps in hedged yields to move back in the U.S.'s favor. The U.S. yield curve has some scope to begin to steepen a bit, especially as U.S. growth accelerates. Additionally, a big component of the underperformance of U.S. hedged yields has been associated with a widening of the LIBOR spread and the cross-currency basis swap spreads (Chart I-10). As we anticipated, the introduction of tax rules favoring repatriations of foreign earnings by U.S. corporations is having this effect.6 U.S. firms hold their offshore earnings in high-quality securities like bank papers or Treasurys. These securities are a vital supply of dollars in the Eurodollar market - the offshore USD market - as they are high-quality collateral that can be used to secure many transactions. As the market in December began to discount the impact of the tax changes, FRA-OIS spreads and basis swap spreads began to widen. This increased the cost of hedging U.S. bonds. Chart I-10Will The Increase In Treasurys Issuance ##br##Pull Back Down The Cost Of Hedging U.S. Assets? But here's one overlooked but potentially friendly outcome of the twin deficits. By increasing its current account deficit, the U.S. economy will begin to supply more USDs to Eurodollar markets, providing a relief valve to the collateral-starved offshore USD-funding markets. Moreover, because the fiscal deficit is set to mushroom, and because after many debt-ceiling debacles the Treasury's cash reserves are low, the Treasury is likely to start issuing a lot more T-Notes and T-Bills, which will also provide a source of high-quality collaterals in the system, especially as the Fed is not buying those bonds anymore. The stress in the funding market may begin to recede and hedged U.S. yields may begin to rise relative to the rest of the world. Bottom Line: While the twin deficit could become a negative for the USD, it is not yet clear that this will indeed be the case. Instead, we need to keep in mind that the U.S. government is injecting a large amount of stimulus in an economy running at full capacity. This could be inflationary. The Fed's response will dictate the USD's path. If the Fed is proactive, the USD will experience an upswing. If the Fed is reactive and waits to guide real rates higher, the dollar could remain weak. In the meanwhile, other forces are pointing toward a rebound in the dollar. The greenback is oversold and unloved; momentum indicators are forming positive divergences, raising the odds of a rebound; global growth is set to slow; and U.S. hedged yields are likely to move back in favor of the dollar. Will EUR/SEK Break Above 10? The recent inflation miss in Sweden has raised some concerns, with EUR/SEK hovering around the critical 10 level, and NOK/SEK breaking above the 1.03 handle. Headline consumer prices rose only 1.6% annually in January, while contracting by 0.8% in monthly terms. The official inflation measure tracked by the Riksbank - the CPIF - fell to 1.7% per annum. This move away from the inflation target has market participants questioning the Riksbank's willingness and ability to normalize policy this year. However, the underlying picture is not that negative. The most recent inflation figure was greatly impacted by the seasonality of Swedish CPI. As Chart I-11 shows, January tends to be a very weak number for Swedish inflation. The February data is likely to rebound significantly. Additionally, our model further highlights that based on both international and domestic factors, Swedish inflation should rise in the coming months, putting CPI much closer to the Riksbank's objective (Chart I-12). Chart I-11Seasonal Pattern In Swedish CPI Chart I-12Swedish Inflation Is Set To Rebound Reassuringly, Swedish inflation expectations have not subsided, suggesting market participants are fading the latest weak reading. As the bottom panel of Chart I-13 illustrates, CPI swap rates are still holding steady. On the macro front, consumers continue to be a source of durable strength. Real consumption is growing at a 3% annual rate, and Swedish consumer confidence is still elevated (Chart I-14). Chart I-13Swedish Inflation Expectations Are Stable Chart I-14The Swedish Consumer Is Still Spending Essentially, the Riksbank's extremely easy monetary policy may not have yet generated inflation in the prices of consumer goods and services, but it has generated huge debt and asset price inflation. The clearest symptom of this is Sweden's non-financial private debt, which now stands at a stunning 240% of GDP, only surpassed by Switzerland and Norway among the G10 economies. These developments imply that the positive Swedish output gap will expand further, and that inflationary pressures will only become more entrenched. Thus, we continue to anticipate a rate hike by the Riksbank this year. This is very much a consensus call. However, where we diverge from consensus is that while futures are pricing in approximately 85 basis points of interest rate hikes by March 2020, we think the scope to lift rates is greater. We also see a higher probability of hikes over that time frame than the Riksbank's own forecast. In other words, we anticipate that the Riksbank's rate forecasts will be revised to the upside. This is because inflationary pressures are growing greater and the economy is very strong. Thus, the Swedish central bank is falling behind the curve and will have to play catch up as soon as inflation moves back closer to target. This will most likely happen over the coming 12 months. As a result, selling EUR/SEK at current levels seems an interesting trade with an attractive entry point. As Chart I-15 illustrates, EUR/SEK only traded above this level during the great financial crisis. It did not manage to punch above this level during the Nordic financial crises of the early 1990s, nor did it during the 1997-'98 crisis - or directly after the September 11 attacks. Chart I-15The Line In The Sand Moreover, EUR/SEK currently trades 7.5% above its purchasing power parity equilibrium. The gap between Sweden's and the euro area's basic balance of payments is very large. While Sweden's stands at 5.1% of GDP, the euro area's is near zero. This reinforces the message that the EUR/SEK is very expensive: when the cross appreciates too much, Swedish assets become much more attractive to foreigners relative to European assets. These long-term flows end up boosting the relative basis balance in favor of Sweden. This is exactly what is happening today (Chart I-16). Chart I-16Expensive EUR/SEK Makes Swedish Assets Attractive From a tactical perspective, EUR/SEK also looks vulnerable. Various short-term momentum measures such as the 14-day RSI or the 13-week rate of change are diverging from actual prices. Additionally, EUR/SEK risk reversals - i.e. the implied volatility of calls versus the implied volatility of puts on this cross - have spiked up. This is true even after controlling for the rise in implied volatility that has affected the option market. It seems to suggest that investors that would have been buying EUR/SEK have already placed their bets. The marginal player is likely to now bet in the other direction. This trade is not without risks. First, a move above 10.1 could be mechanically followed by a sharp rally as stops are hit and momentum traders force the cross higher. Second, Swedish PMIs have been rolling over for six months, but so have the preliminary releases of Europe PMIs this week. What is more concerning is the weakness in Asian manufacturing production that is behind the sharp slowdown in Korean exports. This is worrisome because historically, the Swedish economy has been very sensitive to EM shocks. However, only 2008 was able to push EUR/SEK above 10. Even if EM slows, we are not anticipating a shock as large as what occurred in 2015, let alone in 2008. Moreover, while we anticipate Swedish inflation to surprise to the upside, we equally expect euro area inflation to exhibit much more limited gains. Bottom Line: Sweden's inflation report came in well below expectations, which prompted a sharp rally in EUR/SEK to near 10. However, this level has been an important resistance since the early 1990s, only breached during the great financial crisis. We are betting on it not being breached this time around. The Swedish economy is strong, and inflation is set to pick up again. As a result, we think the Riksbank will be forced to lift its interest rate forecast as time passes. Moreover, EUR/SEK is expensive, and flows are currently very much in favor of Sweden. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, dated February 29, 2018, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "On the MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EM Local Bonds and U.S. Twin Deficits", dated February 21, 2018, available at ems.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot", dated February 2, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Weekly Reports, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and "Canaries In the Coal Mine Alert 2: More on EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Special Report, "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com. Currencies U.S. Dollar U.S. data was mixed: Markit PMIs beat expectations ; Existing home sales, however, grew by less than expected at 5.38 million, a 3.2% contraction form the previous month; Continuing jobless claims outperformed expectations, coming in at 1.875 million; Initial jobless claims also outperformed with 222,000. In the meeting's minutes, FOMC members were quite positive on growth and their rhetoric suggest they intend to follow up on the current set of dot plots. Subsequently, equities sold off, the 10-year yield climbed to 2.954%, bringing them close to BCA's fair value estimate. Due to these developments, the dollar's descent seems to be taking a breather for now, and it may even experience a rebound in the coming weeks. Chart II-1USD Technicals 1 Chart II-2 Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro The tone of European data has been deteriorating: German PMIs underperformed expectations, with services coming in at 55.3, and manufacturing, at 60.3; European PMIs also underperformed anticipations with manufacturing coming in at 58.5 and services at 56.7; The Current Situation section of the ZEW Survey was also weaker than expected; German IFO underperformed expectations, with the Business Climate measure coming in at 115.4, and the Expectations measure also dropping to 105.4. The euro weakened substantially this week on poor data and a hawkish Fed, even if it managed to eke out a rebound on Thursday. We have recently published on the risks to global growth, and the weak European PMIs seem like a consequence of these developments. We expect the euro's bull market to pause until global growth picks back up. Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Recent data in Japan has been mixed: Imports yearly growth underperformed expectations, coming in at 7.9%. It also declined significantly from the previous 14.9% pace . Moreover, Nikkei Manufacturing PMI underperformed expectations, coming in at 54. It also declined from 54.8 in the previous month, However, exports yearly growth outperformed expectations, coming in at 12.2%. It also increased from its 9.3% pace the previous month. USD/JPY has rallied by roughly 1.5% since last week. Overall, we expect that the current volatile environment will provide strength to the yen to the point that a level of 100 for USD/JPY is plausible. However, on a long term basis the yen is likely to be weak against the U.S. dollar, as the BoJ will fight tooth and nail to prevent a strengthening yen from hampering inflation. Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Recent data in the U.K. has been mixed: The ILO Unemployment rate surprised negatively, coming in at 4.4%. It also increased form 4.3% the previous month. Moreover, retail sales and retail sales ex-fuel annual growth also underperformed, coming in at 1.6% and 1.5% respectively. However, average hourly earnings yearly growth excluding bonus outperformed expectations, coming in at 2.5% GBP/USD has depreciated by nearly 1.6% this week. There are currently 45 basis points of hikes by the BoE priced into the next 12-months. We believe that there is not much more upside beyond this, given that the end of the pound's collapse will weigh on inflation. Moreover, recent data has shown that although inflation is high, the economy rests on a shaky foundation. We continue to expect the pound to fall on a trade-weighted basis as well. Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Data out of Australia was mixed: The Westpac Leading Index stayed steady at -0.2%; Wage growth beat expectations, growing at a 0.6% quarterly rate, and 2.1% annual rate; Construction work done slowed down severely, contacting by -19.4%, greatly surpassing the expected 10% contraction. It should also be noted that much of the wage growth was driven by the growth in public sector wages, which grew by 2.4% as opposed to the 1.9% growth experienced by the private sector. RBA members highlighted the risks created by lower than expected wage growth: weaker household consumption as a below-target inflation. The RBA is therefore likely to stay put this year, and the AUD will underperform its G10 peers. Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar The kiwi has fallen by roughly 1% this week, in part due to dollar rebound in the greenback. Nevertheless, AUD/NZD has declined by 0.6%, and is now down almost 3% during the year, thanks to dairy prices surging by more than 13% in 2018. Overall, we expect that the NZD will outperform the AUD, given that the consumer sector in China should outperform the industrial sector, as the Chinese authorities are cracking on overcapacity. With this being said, NZD/JPY will probably see downside, as the current volatility in markets will weigh on this cross. Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Canadian data was weak: Wholesale sales contracted by 0.5% at a monthly pace; Retail sales contracted by 0.8%, underperforming expectations; Core retail sales, excluding autos, contracted by 1.8%. The CAD weakened against all currencies this week. However, even if it may not increase much against the U.S. dollar, the case for a stronger CAD against other major currencies is still firm as the BoC is likely to hike interest rates more than most central banks year. Additionally, stronger U.S. growth should support the health of the Canadian export sector. Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Recent data in Switzerland has been mixed: The trade balance underperformed expectation on January, coming in at CHF1.324 billion. It also declined from last month's value of CHF3.374 billion. However, industrial production yearly growth increased from last month, coming in at a stunning 19.6% pace. EUR/CHF has been relatively flat this week. Overall we believe that the franc can only rally against the euro on episodes of rising global volatility, given that the SNB will fight against any appreciation of the franc that could hurt the little progress that has been made in achieving their inflation target. Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone USD/NOK has rallied by roughly 1.3% on the back of a stronger dollar. Overall, we believe that the krone should be the best performer amongst the commodity currencies, as the economic situation has improved substantially, with the Labour Survey improving last month. This will help the Norges Bank to tighten monetary policy more than the market currently expects. Investors who want to take advantage of these developments should short CAD/NOK as an oil-neutral bet. More audacious traders could short AUD/NOK or NZD/NOK as well. Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Swedish inflation dropped by more than expected: in monthly terms, inflation contracted by 0.8%, while in annual terms it grew by only 1.6%, less than the expected 1.8%. However, this monthly contraction was in line with the seasonal pattern historically witnessed in Swedish inflation, which also tells us that inflation is likely to pick up again in the following months. EUR/SEK hit 10, an historically very strong overhead resistance, indicating that markets may be unnerved by the Riksbank's unwillingness or inability to tighten policy. While the OIS curve is pricing in 80 bps of hikes in the next two years, we believe that the Riksbank will hike more than that, as inflation will come back to Sweden with a vengeance. Not only is the economy firing on all fronts, but the currency is also very cheap. The SEK is likely to strengthen this year. Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades