Money/Credit/Debt
Feature Dear Client, I am travelling this week so this report is a little different. It is the full transcript and slides of a client presentation I recently gave. The presentation summarises several years of in-house work on applying the Fractal Market Hypothesis to real-life investing. Dhaval Joshi The Efficient Market Hypothesis Is Wrong Good morning In the next 30 minutes or so I want to challenge the way you think about financial markets. You see, at school we are taught the mainstream models of financial markets: Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis. And we are led to believe that these models describe the real world. But I'm sad to say that these mainstream models are deeply flawed. They simply don't describe financial markets as they behave in the real world. And in your heart of hearts, you know it. Take the supposed bedrock of financial market theory, the Efficient Market Hypothesis, and look at the assumptions it makes about markets (Slide 2). Slide 2 One. That economic and market returns follow a Normal - which is to say a standard bell-curve - distribution. Really? Everybody knows that returns exhibit 'fat-tails' in which extreme events happen much more frequently than the bell-curve would suggest. By the way, this also means that a statement such as "the financial crisis was a five standard deviation - five-sigma - event with odds of 3 million to 1" is also complete nonsense. Accounting for the true fat-tails, the likelihood of extreme events is much higher than the flawed bell-curve models would suggest, as we should all now be painfully aware! Two. That the distribution is stationary - its mean doesn't change through time. Again, wrong. We know that economies and markets can and do experience regular regime-shifts or phase-shifts. Three. That markets have no memory - they exhibit no trends. Now this is getting silly! We all know that markets exhibit very strong trends. Four. That markets do not produce repeating patterns at any scale. Untrue. And five. That markets are continuously stable at all scales. Wrong again. I'm sure you'll all agree that none of these assumptions that underlie the Efficient Market Hypothesis describe the markets that we all know and work with. The good news is that there is a model that does describe the financial markets as they behave in the real world (Slide 3). It correctly assumes the return distribution is non-Normal, the mean can change over time, markets can trend, produce repeating patterns, and can generate instabilities at any scale. Slide 3 The model is called the Fractal Market Hypothesis, first proposed by Edgar Peters in 1991. Now I can see some looks of fear at the mention of this intimidating word 'fractal'. But hang in there, there really is nothing to fear. A fractal is just a pattern that repeats over and over at different scales. You come across fractals all the time, perhaps without realizing it. A cloud is a fractal - because a small part of a cloud is just a scaled-down version of the whole cloud. And for those of you who enjoy your vegetables, you will notice that cauliflowers and broccoli are fractals because the florets are just miniature versions of the whole vegetable. But perhaps the most familiar example is a tree (Slide 4). You can clearly see that a tree is just a simple pattern repeating over and over at different scales. Indeed, on this next slide (Slide 5), you see images of the twigs, branches, and trunk structure - and you could not tell them apart. Except that the twigs are on a scale of millimeters, the branches are on a scale of centimeters, and the trunk is on a scale of meters. Slide 4 Slide 5 Let's switch back to financial markets. On this next slide (Slide 6), you see three images of ten successive points on the S&P500. Again, the three images look very similar. In fact, they're very different. The first is on a scale of weeks, the second on a scale of months, and the third on a scale of years. But just like the twigs, branches and trunk, you could not tell them apart without seeing the scale. In other words, financial markets are scale-invariant. They are fractals. Slide 6 But why? And so what? To answer these questions we must now introduce the four basic assumptions of the Fractal Market Hypothesis. One. Investors are not homogeneous. The market is composed of many participants with a large number of different time horizons (Slide 7) - ranging from the milliseconds or seconds for a high frequency trader, through the days or weeks for a hedge fund to the years or decades for a pension fund. Two. These different time horizons interpret the same fundamental information differently (Slide 8). For example, a short-term technical trader interprets a rising price as a buy signal. Whereas a long-term fundamental value investor interprets the same information as a sell signal. Slide 7 Slide 8 Three. The market price reflects the combination of the short-term technical trader's interpretation of the information and the long-term value investor's interpretation of the same information (Slide 9). Crucially, this means the market is not efficient unless all time horizons are active in setting the price. Four. The stability of the market at a given price depends on plentiful liquidity - an adequate balancing of supply and demand at that price (Slide 10). When many different time horizons are active, the market is efficient and liquidity is plentiful. This is because different investors will disagree on the interpretation of the same information, and will trade with each other in volume without moving the price. Slide 9 Slide 10 However, if one time horizon becomes dominant, the market becomes inefficient and liquidity will evaporate. As investors become a 'groupthink herd', the healthy disagreement that is needed to create liquidity disappears. And the market loses its stability. So to answer the question 'why' markets are fractals, it is clear that the short-term investors generate the short-term patterns while long-term investors generate the long-term patterns. And to answer the question 'so what', it is clear that if the fractal structure breaks down, it is a warning sign that liquidity is evaporating and the market is losing its stability. Next we must discuss how we can measure the market's fractal structure, and for this I'm going to digress a little and ask you a famous question. How long is Britain's coastline? This is the question that the grandfather of fractals, Benoit Mandelbrot, first asked in 1967. Actually, it's a trick question. The answer is that there is no answer! You see a coastline is also a fractal. And the more detail you capture and measure, the longer it becomes (Slide 11). The point is that with a fractal structure you cannot measure its length or size. But the good news is that you can measure its extent of 'fractal-ness' using something called a fractal dimension. In fact the next slide (Slide 12) shows how Mandelbrot first defined the fractal dimension of Britain's coastline. Slide 11 Slide 12 Then a couple of years ago we thought why don't we extend this concept to a financial market? After all, a price chart is similar to a coastline, except that distance is replaced with time. In fact, the maths is a little more complicated, but this is how we ended up defining the fractal dimension of a financial market (Slide 13). Bear in mind that you won't find this or any of the following analysis in any textbook because it is our own unique work. Rest assured, you don't need the maths to understand the concept intuitively. Think of it like this (Slide 14). A market that is not trending tends to sweep out 2-dimensional space. So its fractal dimension might be close to 2. But a market that is trending gets less and less fractal and closer and closer to a perfect 1-dimensional line. So its fractal dimension drops close to 1. Slide 13 Slide 14 And now we get to our findings, which are both remarkable and uplifting. When we applied our unique definition of fractal dimension to different financial markets in different historical timeframes, we discovered that the tipping point of instability turned out to be exactly the same across different historical eras, geographies and asset classes. We had come across a universal property of financial markets, irrespective of generation, culture or investment. Financial markets tended to reverse their near-term trend when the fractal structure between the 65-day investment horizon and the 1-day investment horizon disappeared. Specifically, when the 65-day fractal dimension dropped to 1.25. So we called this the "Universal Constant Of Finance". You can see that this universal constant applied to the top and initial bottom of the market during the 1929 Wall Street Crash (Slide 15), and to the top and bottom of the 1987 Crash (Slide 16). It also perfectly picked the tops and bottoms of the 1990 Nikkei Crash (Slide 17), and the 1993 Bond Market Crash (Slide 18). Slide 15 Slide 16 Slide 17 Slide 18 Some financial markets also tended to reverse long-term trends when the fractal structure between the 60-month investment horizon and the 1-month investment horizon disappeared. Specifically, when the 60-month fractal dimension dropped to 1.25. You can see here (Slide 19) how this has perfectly picked many of the structural turning points in the dollar. And when we see the rare star-alignment of a long-term signal coinciding with a near-term signal, it can predict a very strong reversal in a short space of time. This is precisely what we saw ahead of crude oil's sharp bounce in early 2016 (Slide 20 and Slide 21). So to conclude (Slide 22): Slide 19 Slide 20 Slide 21 Slide 22 Financial markets are efficient only when all investment horizons are present and active in setting the price. In other words, when the market has a rich fractal structure. When investment horizons converge to a groupthink herd, the fractal structure breaks down, and the fractal dimension nears its lower bound. This is a warning sign of an impending liquidity-triggered trend reversal, either short-term or long-term. I am now happy to take any questions. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com
Highlights There is little evidence of a major "credit bubble" in China. Rising debt is largely the consequence of the country's high saving rate. This has mixed implications for global bonds: On the one hand, an exaggerated fear of a hard landing in China has kept global bond yields below where they would otherwise be; on the other hand, high levels of Chinese savings will continue to weigh on real long-term yields. The real trade-weighted RMB will depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. Chinese shares are still attractive at current valuation levels. Go long the H-share market versus the MSCI EM index. We are booking a loss of 10% on our NASDAQ hedge. Feature Indefatigable The global economy remains in recovery mode. As we discussed last week, leading indicators point to strong global growth and accelerating earnings over the next six months.1 This justifies a cyclically overweight tilt towards global equities. Still, we worry that equity markets have gotten ahead of themselves. We thought that the backup in yields late last year, along with Trump's protectionist rhetoric, would cause stocks to correct to the downside, at least temporarily. Instead, they ripped higher, causing our short NASDAQ hedge trade to briefly go through its 10% stop loss on Wednesday. Our technical indicators continue to point to heightened risks of a correction. Whether such a correction proves to be the proverbial "buying opportunity" - our baseline view - or morphs into something more ominous will depend on the durability of the economic backdrop. We discussed some of the risks around Europe and the U.S. last week. This week we turn to China. The China Question Recent Chinese economic data have been fairly solid and our China analysts expect that growth momentum will be sustained over the coming months.2 Nevertheless, there are plenty of clouds on the horizon. Direct fiscal spending has slowed sharply over the past 12 months. In addition, a crackdown on property speculation last year has led to a deceleration in home price inflation, which could adversely affect household spending and construction later this year. Then, of course, there is all that debt. There is no shortage of commentators who argue that China is experiencing a full-blown credit bubble. Others contend that rising debt in China is largely a manifestation of a chronic excess of domestic savings. Knowing which side is correct is critical for investors. If China is in the midst of a massive credit bubble, then it is natural to fear that this bubble will burst fairly soon. This could prove to be devastating to global financial markets. In contrast, if rising debt in China mainly reflects an overabundance of savings, then it is possible that debt will continue rising until those savings dissipate - something that may not happen for many years. We won't beat around the bush. Our view is that rising debt in China has largely been the result of excess savings. This implies that a financial crisis in China is unlikely anytime soon. That does not mean that China will cease being a source of occasional investor angst. But if another major global recession is coming, it will not be because of China. The Debt-Savings Tango Endless ink has been spilled on the question of whether savings create bank credit or bank credit creates savings. In reality, the answer is "both": Just like income can create spending and spending can create income, savings can create debt and vice versa. If an economy is operating at less than full employment, the decision by banks to extend new credit is likely to boost aggregate demand, leading to more hiring. This will raise household disposable income and potentially lift aggregate savings.3 On the flipside, if households decide to save a bit more, this will push down real interest rates. That, in turn, could entice firms to increase how much they borrow and invest. Debt creates savings, and savings create debt; it's a two-way street. Admittedly, thinking through the specific forces underlying the relationship between debt and savings is one of those things that can make your head spin. Thus, it is worthwhile to go through a few simple examples in order to elucidate the principles at work. With this knowledge in hand, we will be able to debunk many of the fallacies that investors routinely succumb to. Cuckoo For Coconuts: How To Think About Debt And Savings Imagine a small island economy consisting of 100 people, each of whom toils away producing 100 coconuts every year, resulting in annual GDP of 10,000 coconuts. Consider the following five examples, summarized in Table 1: Table 1Cuckoo For Coconuts: Debt Creates Savings, Savings Create Debt Example #1: Each person consumes 100 coconuts. As a result, a total of 10,000 coconuts are consumed. Total savings is zero, as is total investment. No debt is created. Example #2: Each person consumes only 75 coconuts, selling the other 25 coconuts to a nearby plantation. The plantation buys these coconuts with the help of a bank loan and plants them, resulting in 2,500 new coconut trees. Total consumption falls to 7,500. Savings and investment equals 2,500 coconuts. 2,500 coconuts worth of bank loans are created. Notice that higher savings have led to more debt. Example #3: Same as Example 2, but now instead of selling the excess coconuts to a nearby plantation, they are exported abroad. Savings equal 2,500 coconuts, investment is zero, and the current account surplus is 2,500. The island accumulates 2,500 coconuts worth of foreign assets. The lesson here is that if a country can export some of its excess savings abroad, debt may not need to rise by as much as if the savings had to be intermediated by the domestic financial system. Note also that this example reveals the famous economic identity: S-I=CA. Example #4: Each person consumes 125 coconuts, made possible by importing 25 coconuts per person. Consumption now equals 12,500 coconuts. Savings equal -2,500 coconuts, investment is zero, and the current account deficit is 2,500. The island takes on 2,500 coconuts worth of external debt. Example #5: Half the island's residents consume 75 coconuts each, while the other half consumes 125 coconuts each. Those who consume 75 coconuts sell their surplus nuts on the open market, placing the proceeds in a bank. The bank lends out these savings to the other half of the population. Net savings and investment is zero. However, 1,250 coconuts worth of new bank loans are created. Debt Puzzles The key idea stemming from these examples is that debt is often formed when there is a persistent divergence between spending and income.4 This is true for the economy as a whole, as well as for its individual constituents (households, firms, and the government). Understanding this point helps resolve a number of seeming puzzles. For instance, it is sometimes alleged that China's debt buildup cannot be the result of the country's high saving rate because U.S. debt also rose rapidly in the years leading up to the financial crisis, an era during which the U.S. national saving rate was very low. Our simple examples demonstrate why this is a misleading argument. Examples 2, 4, and 5 show that debt levels will rise regardless of whether income exceeds spending or spending exceeds income. It is the absolute difference between the two that matters, not whether the residual is positive or negative. In Example 2, which is applicable to China today, households spend less than they earn. The resulting savings are intermediated by the financial system and transformed into investment, creating new debt along the way. In Example 4, which is applicable to the U.S. before the financial crisis, households spend more than they earn, leading them to take on new debt in order to finance imports. The increase in debt may get amplified, as in Example 5, if some households save while others dissave. As discussed in Box 1, Example 5 also helps explain why inequality and debt levels tend to rise and fall together over time. The Future Of Chinese Household Savings Chinese household savings now stand at nearly 40% of disposable income, notably higher than in other major developed and emerging economies. The increase in China's household savings, along with a widening gap between rich and poor, have been important drivers of faster debt growth (Chart 1). As time goes by, China's household saving rate will begin to decline due to the aging of its population, the expansion of household credit, and the emergence of a stronger "consumer culture." Yet, that shift is likely to be a gradual one. Progress in building out a social safety net has been painfully slow. This has forced households to maintain high levels of precautionary savings. The share of China's population in its 'prime savings years' (between the ages of 30-and-59) will also continue to increase over the next 15 years, which should support an elevated saving rate (Chart 2). Chart 1China: Higher Saving Rate And ##br##Inequality Went Hand In Hand With Debt Growth Chart 2China: Share Of Population In Its High ##br##Saving Years Has Not Yet Peaked In addition, sky-high property prices have forced young people to save a large fraction of their incomes in order to have any hope of owning a home. This is particularly true for men. Brides are in short supply in China. The saving rate among single-child households with one son is about four percentage points higher in rural areas and two percentage points higher in urban areas, compared to single-child households with one daughter. One academic study concluded that about half of the increase in China's household saving rate since the late-1970s could be attributed to this factor.5 Unfortunately, this problem is not going to go away anytime soon. The ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 - a proxy for gender imbalances in the marriage market - will surge from 1.06 at present to 1.35 by the middle of the next decade (Chart 3). What do countries with surplus savings and surplus men tend to do? Historically, the answer is that they have sent them off to fight. China's military spending has grown by leaps and bounds over the past decade (Chart 4). This trend is bound to continue, making East Asia an increasingly likely setting for future military conflicts.6 Chart 3A Shortage Of Chinese Brides Chart 4China: A Lot Of Dry Powder Understanding Chinese Corporate Debt Dynamics Chart 5China: State-Owned Companies Are ##br##Not The Only Ones With Access To Cheap Financing Many companies around the world rely heavily on retained earnings and equity sales to finance new investment projects. When this happens, investment can take place without the need for the creation of new debt. China has its fair share of consistently profitable companies that fund capital expenditures using internally generated funds, while tapping the equity markets as necessary to finance larger projects. However, the country is also awash with companies that are in constant need of debt financing. Perhaps not surprisingly, the former tend to be private firms while the latter are often state-owned enterprises (SOEs). Pundits like to assert that the secret to boosting growth in China is to wean these money-losing public companies off cheap credit, forcing them to cut back on production and capital spending. This will allow scarce economic resources to migrate to better-managed firms that will use them more wisely. But is this really a sensible assumption? What exactly is the evidence that China's well-run private companies have been starved of credit because most of it is flowing to money-losing companies? The data does not fit this "crowding out" story at all (Chart 5). The Japan Analogy A more sensible narrative is that the Chinese government has been prodding state-owned banks into lending money to state-owned companies and local governments in order to support aggregate demand and keep unemployment from rising. The experience of Japan is instructive here. Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 6). In order to keep unemployment from rising, the Japanese government was forced to try to export these excess savings abroad via a current account surplus or, failing that, absorb them with dissavings from the public sector. While Japan was able to lift its current account surplus from 1.4% of GDP in 1990 to 3% of GDP in 1998, this was not enough to fully offset the surge in desired private-sector savings. This necessitated the government to run large budget deficits. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. In effect, China was doing what the islanders in Example 3 were able to do. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 7). Chart 6Japan Relied On Fiscal Largess And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 7China: Debt Increased When Current ##br##Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. Chart 8Chinese Private Firms: Liabilities-To-Assets Trending##br## Lower For A Decade From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt in China is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (Chart 8). Yes, many of the investment projects undertaken by SOEs and local governments are of questionable economic merit. But that's beside the point. China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere." From the Chinese government's point of view, an SOE that is producing something is still preferable to one that is producing nothing. The ever-rising debt burden that these state-owned firms must carry to cover operating losses and finance new investment is just the price the government must pay to keep the economy afloat. Little Evidence Of A Genuine Credit Bubble Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors of the global equity market (Chart 9). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 10). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 11). Chart 9Chinese Banks: Unloved And Unwanted Chart 10Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 11Hong Kong Is The Correct Analogy There is a lot of debt in China. However, most of it has not been centered on the property market (Chart 12). Rather, just as in Japan, debt has served a fiscal purpose - it has been used to absorb the excess savings of the private sector, so as to keep unemployment from rising. Chart 13 shows that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies. China sits close to the trend line, suggesting that its debt stock is roughly what you would expect it to be. Chart 12Chinese Debt: Not Predominately ##br##Tied To The Property Market Chart 13Positive Correlation Between National Savings And Indebtedness Investment Conclusions Where does this leave investors? For global bonds, the implications of our analysis are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Our analysis does not warrant either a very bearish or very bullish stance towards the RMB. Granted, a banking crisis could prompt Chinese savers to look for ways to move more of their money overseas, leading to further capital flight and a tumbling currency. As noted, however, such an outcome is not in the cards. On the flipside, a chronic shortfall of domestic demand will keep the pressure on the government to try to export excess production abroad by running a larger current account surplus. As we foretold in our March 2015 report "A Weaker RMB Ahead," this will push the authorities to weaken the currency.7 We expect the real trade-weighted RMB to depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. If China averts a debt crisis, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions (currency hedged). Despite a weak start to the year, both markets have outperformed the U.S. in local-currency terms since bottoming last summer, a trend we expect will resume over the coming months (Chart 14). What about Chinese shares specifically? Clearly, there are many risks facing the Chinese economy that transcend debt worries, a possible trade war with the U.S. being the prominent example. Yet, considering that Chinese stocks trade at fairly cheap valuation levels, our sense is that these risks have been more than fully priced in by investors. With this in mind, we are going long Chinese H-shares relative to the overall EM basket.8 Chart 15 shows that H-shares now trade at a substantial discount to the EM index. Chart 14Euro Area And Japan: Rebound Will Continue Chart 15Chinese Investable Stocks Are Cheap Finally, one housekeeping note: Since we already have exposure to the H-share market via our strategic recommendation to be long China/Europe/Japan versus the U.S., we are closing that trade and opening a new one that is simply long Europe and Japan versus the U.S. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com Box 1: Debt And Inequality Chart 16U.S.: Positive Correlation Between ##br##Income Inequality And Debt-To-GDP Income inequality and the ratio of private debt-to-GDP have been positively correlated in the U.S. over the past century (Chart 16). The existence of this relationship is not merely due to a third factor: economic growth. Growth was strong in the 1920 and 1980s/90s - two periods of rapidly increasingly inequality - but it was also strong during the 1960s, a decade when inequality was falling. Our analysis helps shed light on this relationship. Return to Example 5, but this time assume that each resident consumes 100 coconuts, with half the population producing 75 coconuts and the other half producing 125 coconuts. 10,000 coconuts are still produced and consumed in aggregate, resulting in no net savings. But because half the population is borrowing money to acquire coconuts from the other half, debt levels still rise. Higher inequality leads to more debt. To be sure, the correlation between inequality and debt runs in both directions. Rising debt has historically led to an expansion of the financial sector. This has helped enrich Wall Street elites. In this way, rising debt can exacerbate inequality. On the flipside, rising income inequality entails a shift of income from poorer households - with high marginal propensities to consume - to richer ones - who generally save a large fraction of their income. This tends to reduce aggregate demand. Lower aggregate demand, in turn, leads to lower real rates, making it easier for poorer households to load up on debt and live beyond their means. 1 Please see Global Investment Strategy Weekly Report, "The Reflation Trade Rumbles On," dated February 17, 2017, available at gis.bcaresearch.com. 2 Please see China Investment Strategy, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 3 A few technical caveats are in order. Think of a simple closed-economy "Keynesian" model where aggregate demand determines income and where savings (S), by definition, are equal to investment (I). In this model, investment is usually treated as exogenous. Thus, if increased bank credit is used to finance new investment projects, this will also translate into higher savings (i.e., if "I" goes up, "S" must also rise). In contrast, if the credit ends up flowing into consumption, savings will remain unchanged. More plausibly, one can imagine that investment is subject to an "accelerator effect," so that increased aggregate demand prompts firms to increase capital spending. In that case, even if the credit flows into consumption, investment will still rise - and since savings is equal to investment, this means that savings will also go up. Intuitively, this happens because the increase in income derived from higher employment more than offsets the increase in consumption. This leads to higher aggregate savings. 4 The word "persistent" is important here. To see why, suppose that in Example 5, the people who consumed 125 coconuts each had previously been thrifty, which had allowed them to build up large bank deposits. Then they could finance their additional spending by running down their accumulated savings, rather than taking on new debt. Likewise, if those who consumed 75 coconuts had previously lived beyond their means, then instead of adding to their deposits, they would be paying back existing debt. The net result would be less debt, not more. 5 Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 6 Please see Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 6, 2015, available at gis.bcaresearch.com. 8 The exact trade is to be long China H-Shares versus the MSCI Emerging Market index, currency unhedged. The corresponding ETFs for this trade are the Hang Seng Investment Index Funds Series: H-Share Index ETF (2828 HK), and the iShares MSCI Emerging Markets ETF (EEM US). The Hang Seng China Enterprise index comprises of China H-Shares (Chinese stocks available to international investors) currently trading on the Hong Kong Stock Exchange. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Empirical evidence shows the clear existence of 'mini-cycles' - with the credit impulse and bond yield cycles 'out of phase' with each other by about 6 months. The credit impulse mini-cycle rolled over in October, suggesting that the bond yield mini-cycle will roll over in April. The bond yield mini-cycle is also approaching a technical limit. Hence, on a 3-month horizon, lean against the rise in bond yields and bank equities. And underweight the bank-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Feature The euro area's flash GDP print for Q4 confirms that the single-currency bloc has been one of the world's top-performing major economies through recent quarters. Furthermore, the latest inflation data confirm that euro area inflation is no different to other major economies when compared on an apples for apples basis - supporting our argument last week in Fake News In Europe.1 Having said that, the economy's latest 'mini-upswing' is likely approaching its end. And according to our framework, the euro area might not be alone in this experience. Mini-Cycles Everywhere Empirically, the economy exhibits very clear 'mini-cycles' whose upswings and downswings last 6-12 months. These economic mini-cycles overlay the much longer business cycle which lasts multiple years. Compelling evidence for these 6-12 month mini-cycles is everywhere. Just look at the credit impulse, the bond yield, commodity price inflation, or perhaps most fundamentally, GDP growth rates (Chart of the Week and Chart I-2, Chart I-3 and Chart I-4). Chart of the WeekThe 6-Month Credit Impulse Rolled Over In October Chart I-2Mini-Cycles In The Bond Yield Chart I-3Mini-Cycles In Commodity Price Inflation Chart I-4Mini-Cycles In 6-Month GDP Growth But bear in mind that to see any cycle it is crucial to focus on the right periodicity. If you look at a clock pendulum once every second, you will not see its cycle. The pendulum will appear motionless. Only when you look at the pendulum once every half-second will you see its regular cycle. Likewise, to see the economic mini-cycles you need to look at rates of change not over a year but over a half-year. The Economy: A Naturally-Oscillating System The economy's clear mini-cycles are the hallmark of any system that possesses two characteristics: Internal regulating feedback. Time delays in the system response to the feedback. As a familiar example, think of the thermostat that controls the central heating in your home. If there is a delay in the thermostat's response to a temperature setting of 20 degrees, the thermostat will switch the heating on and off slightly late. Which will cause the temperature to oscillate perpetually between 19 and 21 degrees, rather than to stay at a constant 20 degrees. A better example is the cruise control on your car. In the internal regulating feedback: the speed regulates the gas pedal; the gas pedal regulates the gasoline flow; the gasoline flow regulates the engine; and the engine regulates the speed. Assuming this internal regulating feedback works instantaneously from start to finish, the car will cruise at a constant 60 mph. But if there are delays in the system response, the speed will oscillate between, say, 58 mph and 62 mph. Now let's translate this to the economy with the following equivalences (Figure I-1): Speed = GDP growth data Gas pedal = Bond yield Gasoline flow = Credit flow Engine = Economy Figure I-1Internal Regulating Feedback + Time Delays = Mini-Cycles In the economy's internal regulating feedback: the GDP growth data regulates the bond yield; the bond yield regulates the credit flow; the credit flow regulates the economy; and the economy regulates the GDP growth data. But just like the cruise control, if there are delays in the system response, the economy will exhibit oscillations. Crucially, there are delays in the economic system response. For a change in the bond yield to register with households and firms and fully impact credit flows, it clearly takes time - empirically in the range of 3-9 months. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows takes time - again empirically in the range of 3-9 months. Once you accept these assumptions of internal regulating feedback combined with clear delays in economic response, the economy has to be a naturally-oscillating system. For those who are mathematically inclined, Box I-1 shows how to derive the differential equation of the economic mini-cycle using first principles. Box I-1The Mathematics Of Mini-Cycles From Theory To Practice So much for the elegant theory, does it actually work? The real economy is complicated by other factors which can stretch and distort the theory. Specifically, aggressive and experimental policy from central banks can cause bond yields to overshoot or undershoot fundamentals. Financial or political shocks can depress animal spirits or, as we have just seen, make them euphoric. A flight to or from safety can distort both bond yields and short-term economic activity. These distortive overlays can shorten or extend the amplitude and/or duration of a mini-cycle. So each mini-cycle is slightly different in size and length from its predecessor. The distortions also explain how a mini-upswing or mini-downswing can become amplified into a boom or recession. The analogy would be a car's cruise control trying to slow the speed to 60 mph whilst also coping with a very steep hill and gale-force headwind. Quite likely, the speed would slow to well below 60 mph. For the past 10 years, aggressive monetary policy shifts, financial shocks and political shocks have been a regular distortive feature of the economic landscape. Yet Chart I-5 clearly shows that 6-12 month mini-upswings and mini-downswings have existed with remarkable consistency and durability through the whole period. Chart I-5The Credit Impulse And Bond Yield Cycles Are 'Out Of Phase' By About 6 Months The empirical evidence shows the clear existence of mini-cycles - with the credit impulse and bond yield cycles 'out of phase' by about 6 months, exactly in line with theory. What Does This Mean For European Investors? The credit impulse mini-cycle rolled over in October. Using the average 6-month lag, this means that the bond yield mini-cycle should roll over in April. However, the current cycle could have a slightly shorter lag or a slightly longer lag than the average cycle. So today, we are delighted to introduce a new piece of proprietary analysis. For the bond yield itself, we can independently assess the extent of groupthink in its recent trend, and how close that is to its limit. Previously, we have done this using its 65-day (3-month) fractal dimension.2 But given that mini-cycle upswings and downswings average 6 months, it is more logical to use a 130-day (6-month) fractal dimension. As readers can see in Chart I-6, this indicator has an excellent track-record in identifying mini-cycle turning points. And it is now signalling that the current trend is reaching its technical limit. Chart I-6A Near-Perfect Indicator For Bond Market Turning Points Bottom Line: On a 3-month horizon, lean against the rise in bond yields3 and bank equities. And underweight the financial-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report, titled "The Use And Abuse Of Liquidity", June 9, 2016 available at eis.bcaresearch.com 3 The house view is tactically below benchmark duration Fractal Trading Model* Pleasingly, both of our most recent trades: short MIB/long Hang Seng and long NOK/RUB hit their profit targets in classic liquidity triggered trend-reversals. This week's trade is to go short Basic Materials equities. 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-7 * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The DXY correction has a bit more to run as G10 economic surprises are likely to roll over. EM-related plays like commodity currencies can rally for a few more months, but the outlook for 2017 is troublesome. China is at risk of a deceleration. Global liquidity is tightening. Protectionism is rising. Feature Dollar Correction: It Ain't Over 'til It's Over Can the dollar correction advance further, or is the dollar bull market about to resume? We prefer to position ourselves for additional dollar weakness in the coming months. Despite persistently high bond yields, the DXY is still softening. It is being dragged down by a euro supported by strong economic news such as this week's Belgian business confidence, our favorite bellwether for the euro area. The pound too continues to show some vigor, which is also a byproduct of economic data pointing toward better growth (Chart I-1). We expect the support for the greenback from higher Treasury yields to be temporary. Momentum in U.S. 10-year government bond yields is driven by G10 economic surprises (Chart I-2). Currently, economic surprises are flirting with the upper end of their distribution of the past 12 years. Chart I-1The British Economy Is Picking Up Chart I-2G10 Economic Surprises Drive Treasury Yields Accentuating the odds of a rollover in surprises are two factors: First, as bond yields and risk-asset prices attest, investors are revising their growth expectations upward, lifting the hurdle for data to surprise to the upside. Second, having expanded for 10 months, the global credit impulse has experienced its longest upswing in a decade. Yet, the increase in global borrowing costs, along with the widening in cross-currency basis swap spreads, points to tightening global liquidity conditions, a poison for the credit cycle (Chart I-3). As credit slows, the economy will deteriorate. Chart I-3The Credit Cycle Is Stretched This means that the key factor that has supported the stronger dollar in recent months - higher U.S. yields - will begin to dissipate, putting downward pressure on the USD. Finally, our dollar capitulation index, after hitting overbought conditions, is now falling. Moreover, it currently stands below its 13-week moving average, conditions under which the greenback has recorded an average 8.1% annualized weekly loss since 1994, and an average 5.3% annualized weekly loss since 2011 (Chart I-4). Chart I-4Negative Momentum For The Dollar We continue to play this correction by shorting USD/JPY. As we have pointed out before, USD/JPY remains a function of the level of global bond yields (Chart I-5). Additionally, a negative surprise in global growth is likely to hurt risk assets. To conclude with the favorable backdrop for the yen, the high degree of uncertainty created by the seemingly erratic policy changes of the new Trump administration suggests that equity implied volatility remains too low. After all, we do not know what changes will hit global tax regimes, what the Fed policy will look like, nor how protectionist Trump will really be. Imbedding a premium for these risks will require higher equity implied vols. A higher VIX tends to support the yen against the USD (Chart I-6). Chart I-5USD/JPY And G10 Bond Yields Chart I-6The Yen Likes Uncertainty Bottom Line: The correction in the dollar should continue, as bond yields still have downside on a one- to three-month basis. The yen remains the best-placed currency to take advantage of these dynamics, especially if risk assets experience a correction. Focus - Emerging Markets and Liquidity: A March To The Scaffold This week, we re-examine our bearish view on emerging markets, a key theme underpinning our bearish stance on commodity currencies. EM assets, and therefore commodity currencies, have outperformed our expectations, reflecting the percolation of previous positive economic surprises in EM relative to the U.S. (Chart I-7). EM and commodity currencies are priced for perfection, with the risk-reversals on EM currencies displaying elevated levels of optimism (Chart I-8). For EM and commodity currencies to rally further, EM economies need to continue to outperform durably. This requires the Chinese economy and the global liquidity backdrop to only improve further. Can this happen? Chart I-7Surprise Beat In EM Versus The U.S. Has ##br##Helped EM And Commodity Currencies Chart I-8EM And Commodity Currencies ##br##Priced For Perfection While the next month or two may continue to generate generous returns for EM-related plays, the rest of 2017 may not prove as kind. The China Syndrome Let's begin with China. The recent upsurge in metal prices has reflected an improvement in Chinese economic activity (Chart I-9). As we have pinpointed before, the Keqiang index is near cycle highs, and, Chinese railway freight volumes have been growing at their fastest pace since 2010. This situation is unlikely to continue much longer. The upsurge in Chinese commodity intake - metals in particular - has been fueled by a vigorous rebound in Chinese real estate construction. However, Chinese real estate price appreciation has hit dangerous levels, and the authorities are already leaning against it, with the PBoC increasing rates by 10 basis points this week. The roll-over in Chinese real estate activity should deepen Chart I-10), hurting commodity prices - particularly iron ore, steel and copper - and commodity currencies along the way. Chart I-9China's Rebound Explains ##br##The Metals Rally Chart I-10The Risk Of A China Real Estate ##br##Slowdown Is Growing Moreover, some of the upswing in Chinese economic activity was also related to large amounts of fiscal stimulus in that nation. In mid-2015, the Middle Kingdom was inching ever closer to a hard landing, prompting a panicked Beijing to boost fiscal support and to speed up the roll-out of US$1.2 trillion of infrastructure public-private partnerships. Today, this fiscal hand-out is fading (Chart I-11). This could once again cause industrial activity and investments to weaken as Chinese capacity utilization remains near recession troughs. The recent disappointing investment growth reading in the latest Chinese GDP release could be a harbinger of this reality. Finally, as we have highlighted last week, Chinese monetary conditions have massively improved as Chinese producer-price inflation rebounded, pushing down Chinese real rates in the process. However, with commodity price inflation set to slow - courtesy of a dissipating base effect and of last year's dollar rally - Chinese PPI should roll over, pulling up real rates and tightening monetary conditions (Chart I-12). A tightening in Chinese monetary conditions represents a big problem for EM as it portends a slowdown in economic activity (Chart I-13). This will ultimately lead to a big drag on DM commodity producers, as EM commodity intake decreases, pushing down the likes of the AUD, CAD, and NZD as their terms of trade suffer. Chart I-11Fading Chinese##br## Fiscal Stimulus Chart I-12Commodity Inflation Will Peak, ##br##So Will Chinese Inflation Chart I-13Tightening China Monetary Conditions##br## Will Hurt EM Economic Activity Bottom Line: In early 2016, global markets were not positioned for a rebound in Chinese economic activity. Yet, Chinese industrial activity improved, resulting in a rebound in EM assets, commodity prices, and commodity currencies. The crackdown on real estate activity, the removal of Chinese fiscal stimulus, and the expected tightening in Chinese monetary conditions should result in a reversal of these trends, hurting commodity producers and their currencies in the process. Global Liquidity In Retreat While China represents a problem for EM plays and commodity currencies, deteriorating global liquidity could prove an even stronger hurdle. Our tactical expectation of a lower dollar and lower rates may support EM plays temporarily, but the cyclical outlook remains grim. To begin with, EM economies are dependent on global liquidity as they run a current account deficit expected to hit US$140 billion in 2017, or US$400 billion if China is excluded. Moreover, they sport large external debts of US$4.8 trillion, excluding Taiwan and China. Especially worrisome are the large funding requirements of many EM countries, especially for Turkey, Malaysia, and Colombia. (Chart I-14). Chart I-14EM Debt Vulnerability Ranking Why is this a problem? Two reasons: Global Interest rates and the dollar. Global Interest rates, driven by higher Treasury yields, are rising as the U.S.'s economic slack vanishes, suggesting that the current tightening campaign by the Fed will be durable (Chart I-15). Higher U.S. rates lift the U.S. dollar against EM currencies, tightening EM liquidity conditions. But an unrelated shock is also putting exogenous upward pressure on the dollar. This force is the widening in LIBOR spreads (Chart I-16). This is the result of the regulation-related 90% melt down in the asset under management of U.S. prime money-market funds, an important source of global dollar liquidity. Moreover, U.S. banks, with their balance sheets under pressure by the binding constraints of Basel III, have not been able to fill the gap. Chart I-15The Fed has A Green Light To Hike Chart I-16Stresses In The Libor Market Remain The end result has been a widening of cross-currency basis swap spreads, which usually tends to boost the dollar (Chart I-17). This phenomenon increases the hedging costs to foreign investors of holding U.S. dollar assets. These investors become increasingly tolerant of purchasing U.S. assets unhedged, pushing up the value of the dollar in the process. This is best illustrated by the fact that net portfolio investments in the U.S. moved from a deficit of US$300 billion in Q1 2015 to a surplus of more than US$550 billion. Yet, hedges put in place, as approximated by the BIS's volume of OTC FX derivatives, have flat-lined since 2013 (Chart I-18). Chart I-17Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Chart I-18Hedging Activity is Receding A rising dollar and LIBOR stresses are tightening global dollar liquidity, creating a big problem for EM. Wider-than-normal cross-currency basis swap spreads have been associated with declining global trade (Chart I-19). The stronger dollar plays a role, as it hurts the price of globally-traded good prices. Also, higher borrowing costs result in a mild disintermediation of global trade flows. As physical exports are 26% of EM GDP versus 13% for the U.S., this represents a huge drag on EM currencies, especially versus the USD. As a corollary, it is also a problem for the small open commodity producing DM economies like Australia, Canada, or New Zealand. Furthermore, the strength in the dollar associated with LIBOR shocks further hurts EM domestic economies by impeding EM credit growth (Chart I-20). The combined assault of a stronger dollar and higher rates increases the cost of EM foreign debt. Also, according to the BIS, between 2002 and 2014, 55% of EM commodity producers' debt issuance has been in USD.1 When the dollar rises, they see both their borrowing costs rise and the prices of the products they sell fall. Altogether, these forces preempt capex and credit accumulation in EM nations. Chart I-19Tightening Global Liquidity##br##Is Bad For Trade Chart I-20A Stronger Dollar Will Hamper##br## EM Credit Growth Bottom Line: The global liquidity backdrop is deteriorating. DM rates are rising cyclically, which is lifting the dollar. Moreover, a global dollar shortage is also supporting the greenback, further hurting EM liquidity conditions. Thus, we expect EM growth to deteriorate, hurting EM assets and commodity currencies. Protectionism The final issue affecting EM economies is the rise of protectionism, especially in the United States. EM - Asia and China in particular - have been the main beneficiaries of globalization (Chart I-21). Currently, they are in the line of sight of President Trump. Thus, we expect that any potential trade war between the U.S. and the rest of the world will focus on EM economies and China. Chart I-21EM And Asia Are In Trump's Line Of Sight EM are much more dependent on the U.S. than the other way around. As an example, China's exports to the U.S account for 3.5% of Chinese GDP, while U.S. exports to China account for less than 1% of U.S. GDP. EM economies have a lot more to lose from a trade war than the U.S. Because of this imbalance in relative trade-exposures, EM economies are at risk from the border-adjustment tax being discussed in the U.S. These taxes would be very deflationary for EM economies as they could force a downward adjustment in EM labor costs and further depress capex in these nations. To ease these adjustments, falling EM exchange rates would be required. Once again, commodity currencies would suffer from these developments. First, lower capex in EM hurts Australian, New Zealand, or Canadian terms of trade. Second, lower EM exchange rates means that that exports from the dollar bloc to EM would suffer. Finally, and most perversely, lower EM exchange rates will give EM commodity producers an advantage versus DM producers, in that a stronger U.S. dollar means their local-currency costs are falling. EM commodity producers would keep producing more than warranted, putting additional downward pressure on commodity prices and stealing market shares from the dollar bloc producers. This is not a pretty picture. Bottom Line: EM should bear the brunt of the pain of any rise in U.S. protectionism. The tight link between EM economies and DM commodity producers suggests that this pain should adversely affect the AUD, the CAD, and the NZD. Risks To Our View Chart I-22Chinese Tariffs Are Falling The biggest risk to our view is a redoubling of Chinese fiscal stimulus. The threat of U.S. tariffs and trade sanctions is obviously deflationary and negative for the Chinese economy. We know this, as do the relevant powers in Beijing. A tool to mitigate any of these negative repercussions on the Chinese economy might be for Beijing to press on the gas pedal once more. Additionally, as our colleague Yan Wang wrote in this week's China Investment Strategy, key members of the new U.S. administration have been on record saying that the threat of tariffs is not an end game, but rather a negotiating tool to extract concessions from U.S. trade partners, implying a potentially more pragmatic stance from the U.S. than current rhetoric suggests.2 Moreover, the Chinese side of the negotiation table is also more open minded than most observers fear. China has been cutting its own tariffs and could continue to do so (Chart I-22). Moreover, Premier Li Keqiang has made a new pledge to move faster toward opening and liberalizing Chinese markets for access by foreign companies. A deal may be less elusive than feared. Finally, regarding the global liquidity deterioration, the recent rebound in gold and silver prices may be a harbinger of improving liquidity conditions globally. We doubt that the economic situation will let this rally be durable, but it remains something to monitor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Bruno Valentina, and Hyun Song Shin, "Global Dollar Credit And Carry Trades: A Firm-level Analysis", BIS, Working Papers, August 205. 2 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard", dated January 6, 2017, available at cis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed this week. The labor market saw both continuing and initial jobless claims rise above expectations. However, the economy is still near full employment and the Fed will not respond to this news. Furthermore, the Beige Book, released last week, also highlights that the U.S. economy remains resilient with employment and pricing activity particularly strong. This week the DXY broke through the key 100 level, as the market continues to reprice capricious assumptions of Trump's policies. Nevertheless, it has rebounded since then. The dollar is unlikely to see any real movement until the administration releases concrete information about its policies. For the time being, the Fed also seems to be on the sidelines in anticipation of more information. Report Links: U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Although the euro area has seen a brighter economic environment as of late, this week's data has been mixed: German and overall euro area services and composite PMI underperformed, while manufacturing PMI outperformed consensus. The IFO Business Climate and Expectations both underperformed consensus, while the Current Assessment remained in line with consensus. All measures still remain over 100. Finally, Belgian Business Confidence accelerated sharply. The ECB is unlikely to change its dovish stance. The euro will therefore see little upside. The recent uptrend in EUR/USD is due to dollar weakness, but the recent downtrend in EUR/GBP and EUR/SEK indicate that the market is not necessarily hopeful that the ECB will reach its inflation target anytime soon. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data indicates that last year's sharp depreciation of the yen is helping the Japanese economy: Exports increased by 5.4% YoY, crushing expectations of 1.2% growth. Nikkei Manufacturing PMI reached 52.8, also beating expectations. In November machinery orders grew by more than 10% YoY. The BoJ will be more resolute on its radical monetary measures, as recent data shows that their approach is working. This will prove very bearish for the yen on a cyclical basis, given that the cap in Japanese rates will cause the rate differential between the U.S. and Japan to widen. In the short term, USD/JPY will resume its correction. We estimate that USD/JPY will cease to be attractive as a short opportunity at around 110. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Tuesday, the Supreme Court upheld the decision of the High Court, requiring a parliamentary vote to authorize the exit of the U.K. from the European Union. This news is an added boon for cable, which has surged by almost 5% after bottoming at 1.20 about 10 days ago. As political risks start to dissipate, and the currency trades more on economic fundamentals, the pound should become a more attractive buy, particularly against the euro, given that the U.K. economy should outperform the market's dismal expectations. Recent data supports this view: Average earning growth outperformed expectations in November. GDP growth was 2.2% YoY in Q4, also outperforming expectations. Furthermore, short-term technicals point to a stronger pound. EUR/GBP has broken through its 100-day moving average, which indicates that momentum should continue to drive this cross downwards for the time being. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Two weeks ago, we argued that the rally in AUD lacks fundamental domestic causes. This week, the momentum of the recent AUD rally, caused by rising iron ore and copper prices, has seemingly paused. Exacerbating this change of pace is recent data which indicates a weak economic backdrop: the RBA trimmed mean CPI, and the more common CPI measure, underperformed consensus at both a quarterly and yearly pace. This could be due to depressed consumer sentiment, as the labor market remains mired in a slump, with the unemployment rate increasing to 5.8%, and total hours worked falling. Given recent data, it is likely that markets reprice growth prospects in Australia. U.S. trade policies could also potentially curtail global trade, painting a bearish picture for AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The Kiwi has appreciated 4.4% since the start of 2017. Although this rally might eventually be limited against the U.S. dollar, the NZD will likely have more upside against its crosses, particularly the AUD. Indeed it seems that low inflation, one of the only sore spots for the RBNZ in an otherwise stellar kiwi economy, has turned the corner, surging to 1.3% on the latest reading Wednesday. More importantly, not only did inflation beat expectations but it also surpassed 1% for the first time since 2014. This is a significant development, given that persistently low inflation in New Zealand was keeping the dovish bias of the RBNZ. With this hurdle gone, and an economy that continues to be the best performing in the G10, this dovish bias should disappear, which will ultimately lift the NZD against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the dissipating oil slump, potential risks may weigh on Canada's future. These risks are likely to emanate from an international sphere. Key concerns revolve around U.S. policies: recent statements have increased yields and tightened financial conditions, but global trade worries are not fully priced in. Recent news indicates that Trump has no ill-intentions aimed at Canada, however, protectionist policies could hurt global trade, indirectly curtailing Canadian exports. A U.S. corporate tax cut can also deviate investment from Canada to the U.S. The recent appreciation in the CAD against major currencies can also hurt Canadian competitiveness going forward. As oil is likely to remain relatively stable in the near future, we may again see a disassociation of CAD with oil, and a continued tight relationship with interest rate spreads. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Yesterday, EUR/CHF fell below the crucial 1.07 level. As we have recommended many times, any time that this cross falls below this threshold, it becomes an excellent buying opportunity. The SNB has not been shy to intervene in the currency markets, and they have been very clear that they will not tolerate any currency strength past a certain threshold as it could add additional deflationary pressures to an economy that has not had a positive inflation rate since 2014. We have identified a level of 1.07 for EUR/CHF as this threshold. Moreover given that the euro is the currency of reference for interventions, the behavior of USD/CHF should roughly mirror the behavior of the dollar against the Euro. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norwegian Krone has rallied along other commodity currencies so far this year, in spite of the meek performance of oil over this timeframe. This surge might prove unsustainable in the short term, as USD/NOK is very close to oversold territory. In the long term, the outlook for the NOK is more positive, particularly against other commodity currencies. Rising oil prices resulting from the OPEC cuts should supercharge the already high inflationary pressures in the Norwegian economy. This factor will eventually push the Norges Bank off its dovish bias, and the NOK higher in the process. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy seems to be finally benefitting from last year's weaker krona; PPI numbers came in at 2.1% MoM, and 6.5% YoY, higher than previous numbers. This will feed into CPI in the near future. Additionally, 1-year, 2-year, as well as the important 5-year Prospera Inflation Expectations have all picked up, with the 5-year at 2%, in line with the Riksbank's target. The bank is aware of the krona's recent strength against major currencies, and realizes that it is important that the appreciation slows. In the short term, the SEK could continue to rally on the back of the dollar's correction and the Swedish economic outperformance vis-à-vis the euro area. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights U.S. policy uncertainty has increased again early in the New Year. President Trump's inaugural speech highlighted that he has not tempered his "America First" policy prescription. The Trump/GOP agenda is still a moving target, but three key risks have emerged for financial markets. A border tax could see a 10% rise in the U.S. dollar. It would also be bearish for global bonds and EM stocks. Position accordingly. Second, President Trump has his sights on China. U.S. presidents face few constraints on the trade and foreign policy side. Investors seem to be under-appreciating the risk of a trade war. Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending. The good news is that the major countries, including China, appear to have entered a synchronized growth acceleration. There is more to the equity market rally than a "sugar high". The global profit recession is over and the rebound has been even more impressive than we predicted. As long as any U.S. protectionist policies do not derail the growth acceleration, corporate EPS in the major countries should rival (traditionally overly-optimistic) bottom-up expectations in 2017. The Fed will hike three times this year, one more than is discounted. The Bank of Japan will continue to target a 10-year JGB yield of 0%, but the ECB will begin hinting at another taper in the fall. Our bond team tactically took profits on a short-duration position, but expect to move back to below-benchmark duration before long. The U.S. policy backdrop is very fluid but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine U.S. growth (our base case), then stocks will beat bonds by a wide margin. Investors should consider long VIX positions, but add to equity exposure on dips. Feature It has become a cliché to describe the economic and financial market outlook as "unusually uncertain". Since 2007, investors have had to deal with rolling financial crises, deleveraging, recession, deflation pressures, quantitative easing, negative interest rates, re-regulation, a collapse in oil prices and Brexit. Chart I-1Stocks Decouple From Policy Uncertainty Now, there is Donald Trump. The new President's inaugural speech highlighted that he has not tempered his "America First" policy prescription. Protectionism, de-regulation and tax reform are high on the agenda but details are scant, leaving investors with very little visibility. There are many policy proposals floating around that have conflicting potential effects on financial markets. Which ones will actually be pursued and how will they be prioritized? Is the U.S. prepared to fight a trade war? Is a border tax likely? Will President Trump push for a "Plaza Accord" deal with China? Even the prospect for fiscal stimulus is a moving target because the Trump Administration is reportedly considering a plan to slash Federal spending by $10 trillion over the next decade! Some have described the global equity rally as just a "sugar high" that will soon fade. No doubt, some of the potentially growth-enhancing parts of the Trump agenda have been discounted in risk assets. Given the highly uncertain policy backdrop, it would be easy to recommend that investors err on the side of caution if the U.S. and global economies were still stuck in the mud. The level of the S&P 500 appears elevated based on its relationship with the policy uncertainty index (shown inverted in Chart I-1). Nonetheless, what complicates matters is that there is more to the equity rally than simply hope. Both growth and profits are surprising to the upside in what appears to be a synchronized global upturn. If one could take U.S. policy uncertainty out of the equation, risk assets are in an economic sweet spot where the deflation threat is waning, but inflation is not enough of a threat to warrant removing the monetary punchbowl. Indeed, the Fed will proceed cautiously and official bond purchases will continue through the year in Japan and the Eurozone. We begin this month's Overview with two key protectionist policies being considered that could have important market implications. We then turn to the good news on the economic and earnings front. The conclusion is that we remain positive on risk assets and bearish bonds on a 6-12 month investment horizon. It will likely be a rough ride, but investors should use equity pullbacks to add exposure. Protectionism Risk #1 A U.S. border tax has suddenly emerged on the U.S. policy program. More formally, it is called a destination-based cash flow tax. Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference the between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred the U.S.). The mechanics are fairly complicated and we encourage interested clients to read a Special Report on the topic from BCA's Global Investment Strategy service.1 The result would be a significant increase in taxes on imported goods and a reduction in taxes paid by exporters. One benefit is that the border tax would generate a large amount of revenue for the Treasury, which could be used to offset the cost of corporate tax cuts. Another benefit is that the tax change would eliminate the use of international "transfer pricing" strategies that allow American companies to avoid paying tax. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field! In reality, there are reasons to believe that the dollar's adjustment would not be fully offsetting. First, much depends on how the Fed responds. Second, some central banks would take steps to limit the dollar's ascent. To the extent that the dollar did not rise by the full amount (25% in our example), then the border tax would boost exports and curtail imports. The resulting tailwind for U.S. growth would eventually be reflected in higher inflation to the extent that the economy is already near full employment. The result is that a border tax would be bullish the dollar and bearish for bonds. Our base case is that a 20% border tax would lift the dollar by about 10% over a 12-month period, above and beyond our current forecast of a 5% gain. The 10-year Treasury yield could reach 3% in this scenario. Subjectively, we assign a 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. It appears that investors are underestimating the likelihood that the U.S. proceeds with this new tax, suggesting that the risks to the dollar and bond yields are to the upside. This is another reason to underweight U.S. bonds relative to Bunds on a currency-hedged basis. For stocks, any growth boost from the border tax would benefit corporate profits, at least until the Fed responded with a faster pace of rate hikes. It is another story for EM equities as a shrinking U.S. trade deficit implies less demand for EM products and shrinking international dollar liquidity. A border tax could be seen as the first volley in a global trade war, souring investor sentiment towards EM stocks. Another major upleg in the U.S. dollar could also spark a financial crisis in some EM countries with current account deficits and substantial dollar-denominated debt. Protectionism Risk #2 Chart I-2Trade War Risk Is Elevated While President Trump wants a smaller trade deficit generally, he has his sights on China because of the elevated U.S. bilateral trade deficit (Chart I-2). His choices for Commerce Secretary, National Trade Council and U.S. Trade Representative are all China critics. U.S. presidents face few constraints on the trade and foreign policy side. He can order tariffs on specific goods, or even impose a surcharge on all dutiable goods, as Nixon did in 1971. Congress is unlikely to be a stumbling block. Trump's election was a signal that the U.S. populace wants protectionist policies. His electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. We expect the Trump Administration to give a largely symbolic "shot across China's bow" in the first 100 days, setting the stage for formal trade negotiations in the subsequent months. The initial shot will likely rattle markets. A calming period will follow, but this will only give a false sense of security. The U.S. is in a relatively good negotiating position because China's exports to the U.S. are much larger than U.S. exports to China. However, tensions over the "One China" policy and international access to the South China Sea will greatly complicate the trade negotiations. The bottom line is that there is little hope that U.S./China relations will proceed smoothly.2 A long position in the VIX is prudent given that the market does not appear to be adequately discounting the possibility of a trade war. Synchronized Global Growth Upturn While the U.S. policy backdrop has become more problematic for investors, the global economic and profit picture has brightened considerably. We were predicting a pickup in global growth before last November's election based on our leading indicators and the ebbing of some headwinds that had weighed on economic activity early in 2016. As expected, the manufacturing sector is bouncing back after a protracted inventory destocking phase. The stabilization in commodity prices has given some relief to emerging market manufacturers. The drag on global growth from capex cuts in the energy patch is moderating even though the level of capital spending will contract again in 2017. Moreover, the aggregate fiscal thrust for the advanced economies turned positive in 2016 for the first time in six years. The major countries, including China, appear to have entered a synchronized growth acceleration. The pick-up is confirmed by recent data on industrial production, purchasing managers' surveys and the ZEW survey (Chart I-3). The global ZEW composite has been a good indicator for world earnings revisions and the global stock-to-bond return ratio. The synchronized uptick in global coincident and leading economic data, including business and consumer confidence, suggests that there is more going on than a simple post-election euphoria. Euro Area sentiment measures hooked up at the end of 2016 and the acceleration in growth appears to be broadly based (Chart I-4). A simple model based on the PMI suggests that Eurozone growth could be as much as 2% this year, which is well above trend. Chart I-3Positive Global Indicators Chart I-4Euro Area To Beat Growth Estimates While Japan will not be a major contributor to overall global growth given its well-known structural economic impediments, the most recent data reveal a slight uptick in consumer confidence, business confidence and the leading economic indicator (Chart I-5). We have noted the impressive rebound in China's leading and coincident growth indicators for some time. Some indicators are consistent with real GDP growth well in excess of the 6.7% official growth figure for 2016 Q4. Both the OECD leading indicator and our proprietary GDP growth model are calling for faster growth in 2017 (Chart I-6). A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny picture. Nonetheless, given what we know about the underlying economy at the moment, China looks poised to deliver another year of solid growth. Chart I-5Even Japanese Sentiment Is Turning Up Chart I-6Upside Risk To China's Growth In the U.S., President Trump appears to be stirring long-dormant animal spirits. CEOs are much more upbeat and several regional Fed surveys indicate a surge in investment intentions (Chart I-7). Spending on capital goods has the potential to soar given the historical relationship with the survey data shown in Chart I-8 (the caveat being that Congress will need to deliver). Even the long depressed small business sector is suddenly more optimistic. The December reading of the NFIB survey showed a spike in confidence, with capital expenditures, hiring plans and overall optimism returning to levels not seen in this expansion. Chart I-7Animal Spirits Reviving In The U.S.... Chart I-8...Which Will Spark Capital Spending There is a good chance that a deal between the White House and Congress on tax reform will occur in the first half of 2017, including a major tax windfall for the business sector that would boost the after-tax rate of return on equity. Nonetheless, past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer demand is on the upswing. In other words, consumers need to move first. On that score, a number of cyclical tailwinds have aligned for household spending. Credit scores have largely been repaired since the recession and income growth is on track to accelerate (Chart I-9). Despite a moderation in monthly payrolls, overall income growth is likely to stay perky, now that wage gains are on an upward path. And, importantly, various surveys highlight an improvement over the past year in consumer confidence about long-term job prospects. The propensity to spend rather than save is higher when households feel secure in their jobs. Chart I-10 highlights that the saving rate tends to decline when confidence is elevated. The wealth effect from previous equity and housing price gains has been a tailwind for some time but, until now, consumers have held back because it seemed to many that the recession had never ended. Chart I-9Share Of Home Mortgage Borrowers ##br##Who Recovered Pre-Delinquency Credit Score After Foreclosure Chart I-10Room For U.S. Consumer To Spend In other words, there are increasing signs that the scar tissue from the Great Recession is finally fading, at a time when tax cuts are on the way. We expect that U.S. real GDP growth will be in the 2½-3% range this year with risks to the upside, as long as the Trump Administration does not start a trade war that undermines confidence. Corporate Earnings Liftoff Chart I-11Profits Are Bouncing Back The good news on the economy carries over to corporate earnings. The profit recession is over and the rebound has been even more impressive than we predicted (Chart I-11). Eurozone EPS "went vertical" near the end of 2016. Blended S&P 500 Q4 bottom-up estimates reveal a huge increase in EPS last year to $109 (4-quarter trailing), providing an 8.5% growth rate for 2016 as a whole. The 4-quarter trailing growth figure will likely surge again to 16% in 2017 Q1, even if the sequential EPS figure is flat. Some of the growth acceleration is technical, reflecting a particularly sharp drop in profits at the end of 2015 (which will eventually fall out of the annual growth calculation). Of course, a spike in energy earnings on the back of higher oil prices made a major contribution to the overall growth rate, but there is more to it than that. Consumer Discretionary, Financials and Health Care all posted solid earnings figures last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is benefiting from favorable comparisons. Dollar strength has pushed the U.S. earnings revisions ratio slightly into negative territory, while revisions have surged into positive terrain in the other major markets (Chart I-12). The sharp upturn in our short-term EPS indicators corroborates the more upbeat earnings outlook for at least the next few months (Chart I-13). Chart I-12Earnings Revisions Chart I-13Short-Term EPS Indicators Are Bullish Our medium-term profit models also paint a constructive picture for equities. These are top-down macro models that include oil prices, exchange rates, industrial production (to capture top-line dynamics), and the difference between nominal GDP and labor compensation (to capture margin effects). Given our more optimistic economic view, the model forecasts for 2017 EPS growth have been revised higher for the global aggregate and each of the major developed markets (Chart I-14). The U.S. is tricky because of the impact of comparison effects that will add volatility to the quarterly growth profile as we move through the year. We are now calling for a 10% gain for 2017 as a whole, which is just shy of the roughly 12% increase expected by bottom-up analysts. This is impressive because actual market expectations are typically well below the perennially-optimistic bottom-up estimates. A 10% EPS growth figure might seem overly optimistic in light of the dollar appreciation that has occurred since last November. Some CEOs will no doubt guide down 2017 estimates during the current earning season. However, in terms of EPS growth, the annual change in the dollar matters more than its level. Chart I-15 shows that the year-over-year rate of change in the dollar is moderating despite the recent rise in the level. This is reflected in a diminishing dollar drag on EPS growth as estimated by our model (bottom panel in Chart I-15). We highlighted in the December 2016 monthly report that it does not require a major growth acceleration to overwhelm the negative impact of a rising dollar on earnings. Chart I-14Medium-Term Profit Models Are Also Bullish Chart I-15Dollar Effect On U.S. EPS The models for Japan and the Eurozone point to 2017 EPS growth in the mid-teens. Both are roughly in line with bottom-up estimates which, if confirmed this year, would be quite bullish for stock indexes. Keep in mind that these projections do not include our base case forecast that the U.S. dollar will appreciate by another 5% this year (more if a border tax is enacted). Incorporating a 5% dollar appreciation would trim U.S. EPS growth by 1 percentage point and add the same amount to profit growth in Japan and the Eurozone. The bottom line is that we expect corporate profits to be constructive for global bourses this year. Within an overweight allocation to equities in the advanced economies, we continue to favor the European and Japanese markets versus the U.S. As we discussed in the 2017 Outlook, political risks in the Eurozone are overblown. Currency movements and relative monetary policies will work against U.S. stocks on a relative (currency hedged) basis. FOMC: Hawks Gradually Winning The Debate Fed officials are in a state of quandary over how the policies of the incoming Administration will affect the growth and inflation outlook. Nevertheless, the last FOMC Minutes confirmed that the consensus on the Committee is still shifting in a less dovish/more hawkish direction. The tone of the discussion was decidedly upbeat, especially on the manufacturing and capital spending outlook. "Most" of the meeting participants felt that the U.S. economy has reached full employment, although there is still an ongoing debate on the benefits and costs of allowing the unemployment rate to temporarily move below estimates of full employment. Running the economy "hot" for a while might draw more discouraged workers back into the workforce and thereby expand the supply side of the economy. Other members, however, highlight that past attempts by the Fed to fine tune the economy in this way have always ended in recession. Our view is that the FOMC will not follow the Bank of Japan's example and explicitly target a temporary inflation overshoot. Conversely, the Fed will not attempt to pre-emptively offset any forthcoming fiscal stimulus either (if indeed there is any net fiscal stimulus). Policymakers will watch the labor market and, especially, wage and price inflation to guide them on the appropriate pace of rate hikes. Core PCE inflation is roughly 30 basis points below target and has only edged erratically higher over the past year. The pickup in shelter inflation has been largely offset by falling core goods prices, reflecting previous dollar strength. We expect shelter inflation to soon flatten off, but goods prices will continue to contract if the dollar rises by another 5% this year. Year-ago comparison effects will also depress the annual rate of change over the next couple of months. However, the key to the underlying inflation trend will be wage pressures, which are most highly correlated with the non-shelter part of the service component. Up until recently, the structural and cyclical forces acting on wage gains were pulling in the same downward direction. Structural factors include automation and population aging; as high-paid older workers leave the workforce, the vast majority of new entrants to full-time employment do so at below-median wages, putting downward pressure on median earnings growth.3 These structural factors will not disappear anytime soon, but the cyclical forces have clearly shifted. The main measures of U.S. wage growth are all trending higher. Excess labor market slack appears to have been largely absorbed. Only the number of people working part time for economic reasons suggests that there is some residual slack remaining. To what extent will cyclical wage pressures exert upward pressure on inflation? That will depend on the ability of companies to raise prices in order to protect profit margins. Wage inflation trends do not lead, and sometimes diverge from, inflation in goods and services. Theory suggests that there is a two-way relationship between wages and prices. Sometimes inflation starts in the labor market and spills over into consumer prices (cost-push inflation), and sometimes it is the other way around (demand-pull inflation). At the moment, the corporate sector appears to have limited ability to pass on rising wage costs. Balancing off the opposing factors, we believe that core PCE inflation will grind higher and should be near the 2% target by year end. This would end the Fed's debate over whether to run the economy hot, helping to keep upward pressure on Treasury yields. Bond Bear To Return Chart I-16Watch Bond Technicals To Short Again Global yields troughed a full four months before the U.S. election. As discussed above, the U.S. and global economies were showing signs of increased vigor even before Trump won the Presidency. The new President's policies reinforce the bond-bearish backdrop, especially protectionism and fiscal stimulus, at a time when the economy is already near full employment. Long-term inflation expectations imbedded in bond yields have shifted up in recent months across the major markets. Real yields have been volatile, but generally have not changed much from late last year. We remain modest bond bears over a 6-12 month horizon. Inflation and inflation expectations will continue to grind higher in the major markets and we expect the FOMC to deliver three rate hikes in 2017, one more than is discounted in the Treasury market. A rise in 10-year TIPS breakevens into a range that is consistent with the Fed's 2% inflation target (2.4%-2.5% based on history) would be a strong signal that the Fed will soon lift the 'dot plot.' ECB bond purchases will limit the increases in the real component of core European yields, but any additional weakness in the euro would result in a rise in European inflation. The ECB was able to announce a tapering of monthly purchases last year while avoiding a bond rout by extending the QE program to the end of 2017, but this will be more difficult to pull off again if inflation is on the rise and growth remains above-trend this year. We expect the ECB to provide hints in September that it will further taper its QE program early in 2018. Thus, the Eurozone bond market could take over from U.S. Treasurys as the main driver of the global bond bear market late in 2017. The Japanese economy is also performing impressively well, reducing the probability of a "helicopter drop" policy. The dollar's surge has depressed the yen and lifted inflation expectations, relieving some pressure on PM Abe to ramp up fiscal spending beyond what is already included in the supplementary budgets. In any event, the BoJ will keep the 10-year yield pinned near to zero, limiting the upside for bond yields to some extent in the other major bond markets. That said, we are neutral on JGBs, not overweight, because most of the yield curve is in negative territory. We remain overweight Bunds versus both Treasurys and JGBs on a currency-hedged basis. In terms of the duration call, our bond strategists felt in early December that the global bond selloff had progressed too far, too fast (Chart I-16). They recommended temporarily taking profits on short-duration positons and shifting to benchmark, which turned out to be excellent timing. Yields have drifted lower since then and the technicals have improved enough to warrant shifting back to below-benchmark duration. Investment Conclusions Chart I-17A Better Growth ##br##Backdrop For USD Strength Equity markets have gone into a holding pattern as investors weigh heightened U.S. policy risk against the improving profit and global macro backdrop. The latter appears to have broken the Fed policy loop that had been in place for some time. Expectations for a less dovish Fed helped to drive the dollar and Treasury yields higher late in 2016. But, rather than sparking a correction in risk assets as has been the case in recent years, stock indexes surged to new highs (Chart I-17). The difference this time is that there has been a meaningful improvement in the growth and profit outlook that has overwhelmed the negative impact of a stronger dollar and higher borrowing rates. The protectionist policies currently being considered are clearly dollar bullish, and bearish for global bonds and EM stocks. Investors should be positioned accordingly. It is more complicated for stocks. The passing of a major tax reform package would no doubt buttress the budding revival in private sector animal spirits, but a nasty trade war has the potential to do the opposite. The multitude of policy proposals floating around greatly complicate asset allocation. It is a very fluid situation but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine global growth (our base case), then corporate earnings growth will be solid in 2017 and stocks will beat bonds by a wide margin. We wish to be clear, though, that equities are on the expensive side in most of the main markets. This means that overweighting equities and underweighting cash and bonds in a balanced global portfolio is essentially playing an equity overshoot. It may end badly, but the overshoot is likely to persist for as long as the economic and profit upswing persists. Investors should consider long VIX positions, but add to equity exposure on dips. Our view on corporate bonds is unchanged this month. Poor value and deteriorating corporate balance sheet health make it difficult to recommend anything more than a benchmark position in the U.S. relative to Treasurys. However, investors can pick up a little spread in the Eurozone corporate bond market, where balance sheet health is better and the ECB is soaking up supply. Mark McClellan Senior Vice President The Bank Credit Analyst January 26, 2017 Next Report: February 23, 2017 1 U.S. Border Adjustment Tax: A Potential Monster Issue for 2017. BCA Global Investment Strategy service, January 20, 2017. 2 For more information, please see: Trump, Day one: Let the Trade War Begin. BCA Geopolitical Strategy Weekly Report, January 18, 2017. 3 For more information in the structural and cyclical wage pressures, please see: U.S. Wage Growth: Paid in Full? U.S. Investment Strategy Service, November 28, 2016. II. Global Debt Titanic Collides With Fed Iceberg? The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. The "cash flow" effect on debt service is a headwind for growth as rising interest payments trim the cash available to spend on goods and services. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will be so severe this time that it will quickly derail the economic expansion. However, a number of factors make projecting interest payments complicated, such that back-of-the-envelope estimates are quite misleading. In order to provide a sense of the size of the cash-flow effect, in this Special Report we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100 basis points from today's levels. It would require a 300 basis point jump to really "move the dial". Interest rate shocks are more dramatic for the Japanese government interest burden due to the size of the JGB debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. We are not downplaying the risks posed by the rapid accumulation of debt since the Great Recession. Rather, our aim is to provide investors with a sense of the debt-service implications of a further rise in borrowing rates. Our main point is that the cash-flow effect of higher interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Investors are justifiably worried that the bond selloff will get ahead of itself, spark an economic setback and a corresponding flight out of risk assets. After all, there have been several head fakes during this recovery during which rising bond yields on the back of improving data and optimism were followed by an economic soft patch and a risk-off phase in financial markets. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. Indeed, global debt has swollen by 41½ percentage points of GDP since 2007 (Chart II-1). Households, corporations and governments tried to deleverage simultaneously to varying degrees in the major countries since the Great Recession and Financial Crisis, but few have been successful. Households in the U.S., U.K., Spain and Ireland have managed to reduce the level of debt relative to income. U.K. and Japanese corporations are also less geared today relative to 2007. Outside of these areas, leverage has generally increased in the private and public sectors (see Chart II-2 and the Appendix Charts beginning on page 37). The astonishing pile-up of debt in China has been particularly alarming for the investment community (Chart II-3). Chart II-1Leverage Has Increased Since 2007 Chart II-2Leverage In Advanced Economies Chart II-3China's Alarming Debt Pile-Up Governments can be excused to some extent for continuing to run fiscal deficits because automatic stabilizers require extra spending on social programs when unemployment is high. Fiscal policy was forced to at least partially offset the drain on aggregate demand from private sector deleveraging, or risk a replay of the Great Depression. More generally, history shows that it is extremely difficult for any one sector or country to deleverage when other sectors and countries are doing the same. The slow rate of nominal income growth makes the job that much harder. Borrowing Rates And The Economy There are several ways in which higher borrowing rates can affect the economy. Households will be incentivized to save rather than spend at the margin. Borrowing costs surpass hurdle rates for new investment projects, causing the business sector to trim capital spending. Uncertainty associated with rising rates might also undermine confidence for both households and firms, reinforcing the negative impact on demand. Banks, fearing a growth slowdown ahead and rising delinquencies, may tighten lending standards and thereby limit credit availability. These negative forces are normally a headwind for growth, but not something that outweighs the positive Keynesian dynamics of rising wages, profits and employment until real borrowing rates reach high levels. However, if the neutral or "equilibrium" level of interest rate is still extremely low today, then it may not require much of a rise in market rates to tip the economy over. A lot depends on confidence, which has been quite fragile in the post-Lehman world. The "cash flow" effect on debt service is another headwind for growth as rising interest payments trim the cash available to spend on goods and services. For the government sector, a swelling interest burden will add to the budget deficit and may place pressure on the fiscal authorities to cut back on spending in other areas. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will quickly derail the expansion in the U.S. and potentially in other countries as the Treasury market selloff drags up yields across the global bond market. This is an argument that has circulated at the beginning of every Fed tightening cycle as far back as we can remember. Some even predict that central banks will be forced to use financial repression for an extended period to prevent the interest burden from skyrocketing and thereby short-circuiting the economic expansion. Back-of-the-envelope estimates that simply apply a 100 or 200 basis point increase in borrowing rates to the level of outstanding debt, for example, imply a shocking rise in the debt service burdens. Fed rate hikes could be analogous to the iceberg that took down the Titanic in 1912. Key Drivers Of Interest Sensitivity However, back-of-the-envelope calculations like the one described above paint an overly pessimistic picture for three reasons. First, the starting point for debt service burdens in the corporate, household and government sectors is low (Chart II-4). These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China.1 Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years (Chart II-5). The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5-years and more in some countries. Households have been extending the maturity structure of their debt in recent decades (Chart II-5, bottom panel). Chart II-4Debt Service Has Generally Declined Chart II-5Average Maturity Of Debt Is Long Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100 basis points in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). In this Special Report, we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. We could not include China in this month's analysis because data limitations precluded any degree of accuracy, but the sheer size of China's debt mountain justifies continued research in this area. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates rise immediately by 100 basis points from today's levels. It would require a 300 basis point rise in yield curves to really "move the dial" in terms of the cash-flow impact on spending. An interest rate shock of that size would be particularly dramatic for the Japanese government interest burden given the size of its debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. Consumer Sector U.S. households have worked hard at deleveraging since their net worth was devastated by the housing bust. Still, the overall debt-to-income level is elevated by historical standards. U.S. household leverage has generally trended higher since the Second World War and has been a source of angst for investors as far back as the late 1950s. Yet, we find no evidence that U.S. consumers have become more sensitive to changes in borrowing rates over the decades.2 This counter-intuitive result partially reflects the fact that consumers have partially insulated themselves from rising interest rates by adopting a greater proportion of fixed-rate debt. The bottom panel of Chart II-6 presents the two-year change in debt service payments expressed as a percent of income (i.e. the swing or the "cash flow" effect). The fact that these swings have not grown over time suggest that the cash-flow effect of changes in interest rates on debt service has not increased.3 Chart II-6U.S. Consumers Have Not Become More Sensitive To Interest Rates Another way to demonstrate this point is to compare disposable income growth with a measure of "discretionary" disposable income that subtracts debt service payments (Chart II-6, top panel). This is the amount of money left over after debt servicing to purchase goods and services. The annual rate of growth in disposable income and discretionary income are nearly identical. In other words, growth in spending power is determined almost exclusively by changes in the components of income (wages, hours and employment). Moreover, the fact that some households are net receivers of interest income provides some offset to rising interest payments for other households when rates go up. This conclusion applies to households in the other major countries as well. Charts II-7 to II-10 present projections for household interest payments as a percent of GDP under three scenarios: no change in yield curves, an immediate 100 basis point parallel shift up in the yield curve and a 300 basis point shift. Assuming an immediate increase in yields across the curve is overly blunt, but the scenarios are only meant to provide a sense of how much interest payments could rise on a medium-term horizon (say, one to five years). The exact timing is less important. Chart II-7U.S. Household Sector Interest Payment Projection Chart II-8U.K. Household Sector Interest Payment Projection Chart II-9Japan Household Sector Interest Payment Projection Chart II-10Eurozone Household Sector Interest Payment Projection Unsurprisingly, household interest payments as a fraction of GDP are flat-to-slightly lower in "no change" interest rate scenario for the major countries. The interest burden increases by roughly 1 percentage point in the 100 basis point shock, although the level remains well below the pre-Lehman peak in the U.S., U.K. and Eurozone. In Japan, the interest payments ratio returns to levels last seen in the late 1990s, although this is not particularly onerous. A 300 basis point shock would see interest burdens ramp up to near, or above, the pre-Lehman peak in all economies except in the U.K. For the latter, borrowing rates would still be below the 2007 peak even if they rise by 300 basis points from current levels. This scenario would see the household interest burden surge well above 3% of GDP in Japan, a level that exceeds the entire history of the Japanese series back to the early 1990s. Also shown in the bottom panel of Chart II-7, Chart II-8, Chart II-9, Chart II-10 is the associated 2-year swing in interest expense as a percent of GDP under the three scenarios. The 2-year swing moves into positive (i.e. restrictive) territory for all economies under the 100 basis point shock, although they remain in line with previous monetary tightening cycles. It is only for the 300 basis point scenario that the cash-flow effect appears threatening in terms of consumer spending power over the next two years. Corporate Sector The starting point for interest payments and overall debt-service in the corporate sector is also quite low by historical standards, although less so in the U.S. Falling interest rates have been partially offset by the rapid accumulation of American company debt in recent years. We modeled national accounts data for non-financial corporate interest paid using the stock of corporate bonds, loans and (where relevant) commercial paper, together with the associated interest or coupon rates. The model simply sums interest payments across these types of debt to generate a grand total, after accounting for the maturity structure of the loans and debt. Chart II-11, Chart II-12, Chart II-13 and Chart II-14 present the three yield curve scenarios for corporate interest payments. The interest burden is flat-to-somewhat lower if yield curves are unchanged, as old loans and bonds continue to roll over at today's depressed levels. Even if market yields jump by 100 basis points tomorrow, the resulting interest burdens would rise roughly back to 2012-2014 levels in the U.S., Eurozone and the U.K., which would still be quite low by historical standards. The resulting two-year cash-flow effect is modest overall. The rate increase feeds into corporate interest payments somewhat more quickly in the Eurozone and Japan because of the relatively shorter average maturity of the corporate debt market, but a shock of this size does not appear threatening to either economy. Chart II-11U.S. Corporate Sector Interest Payment Projection Chart II-12U.K. Corporate Sector Interest Payment Projection Chart II-13Eurozone Corporate Sector Interest Payment Projection Chart II-14Japan Corporate Sector Interest Payment Projection It is a different story if yields rise by 300 basis points. The interest ratio approaches previous peaks set in the 2000s in the U.S. and Eurozone. The interest ratio rises sharply for the U.K. corporate sector as well, although it stays below the 2000 peak because interest rates were even higher 17 years ago. Japanese companies would also feel significant pain as the interest ratio rises back to where it was in the late 1990s. Government Sector Government finances are not at much risk from a modest increase in bond yields either (Chart II-15). We focus on the level of the interest burden rather than the cash-flow effect for the government sector since changes in interest payments probably have less impact on governments' near-term spending plans than is the case for the private sector. Chart II-15Government Sector Interest Payment Projection As discussed above, Treasury departments in the U.K., Eurozone and Japan have taken advantage of ultra-low borrowing rates by extending the average maturity of public debt. The average maturity of the Barclays U.K. government bond index has extended to 16 years, while it is close to 10 years in Japan and the Eurozone (Chart II-5). The U.S. Treasury has not followed suit; the Barclays U.S. index is about 7½ years in maturity. The lengthy average maturity means that index coupon rates will continue to fall for years to come if rates are unchanged in the U.K., Japan and the Eurozone, resulting in a declining interest burden. Even if rates rise by another 100 basis points, the interest burden is roughly flat as a percent of GDP for the U.K. and Eurozone, and rises only modestly in Japan. The limited impact reflects the fact that the starting point for current yields is well below the average coupon on the stock of government debt. In contrast, the U.S. interest burden is roughly flat in the "no change" scenario, and rises by a half percentage point by 2025 in the 100 basis point shock scenario. Keep in mind that we took the neutral assumption that the stock of government debt grows at the same pace as nominal GDP growth. This assumes that governments deal effectively with the impact of aging populations on entitlement programs in the coming years. As many studies have shown, debt levels will balloon if entitlements are not adjusted and/or taxes are not raised to cover rising health care and pension costs. We do not wish to downplay this long-term risk, but we are focused on the impact of higher interest rates on interest expense over the next five years for the purposes of this Special Report. As with the household and corporate sectors, the pain becomes much more serious in the event of a 300 basis point rise in interest rates. Interest payments rise by about 1 percentage point of GDP in the U.S. and U.K. to high levels by historically standards. It takes a decade for the full effect to unfold, although the ratios rise quickly in the early years as the short-term debt adjusts rapidly to the higher rate environment. For the Eurozone, the roughly 100 basis points rise takes the level of the interest burden back to about 2003 levels (i.e. it does not exceed the previous peak). Given Japan's extremely high government debt-to-GDP ratio, it is not surprising that a 300 basis point rise in interest rates would generate a whopping surge in the interest burden from near zero to almost 5% of GDP by the middle of the next decade. Nonetheless, this paints an overly pessimistic picture for two reasons. First, the Bank of Japan is likely to hold short-term rates close to zero for years as the authorities struggle to reach the 2% inflation target. This means that only long-term JGB yields have room to move higher in the event of a continued global bond selloff. Second, 40% of the JGB market is held by the central bank and this proportion will continue to rise until the Bank of Japan's QE program ends. Interest paid to the BoJ simply flows back to the Ministry of Finance. The net interest payments data used in our analysis are provided by the OECD. These data net out interest payments made between all arms of the government except for the central bank. The implication is that rising global bond yields in the coming years will not place the Japanese government under any fiscal strain. The same is true in the U.S., U.K. and Eurozone, where the respective central banks also hold a large portion of the stock of government debt (although this conclusion does not necessarily apply to the peripheral European governments). Conclusion The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs given the sea of debt that has accumulated. As discussed in our 2017 BCA Outlook, we believe that the secular bond bull market is over but foresee only a gradual uptrend in yields in the coming years. Inflation is likely to remain subdued in the major countries and bond supply will continue to be absorbed by the ECB and Bank of Japan. The stock of government bonds available to the private sector will drop by $750 billion in 2017 for the U.S., Eurozone, Japan and the U.K. as a group. This follows a contraction of $546 billion in 2016. Forward guidance from the BoJ and ECB will also help to cap the upside for global bond yields. Still, we believe that the combination of gradually rising U.S. inflation, Fed rate hikes and the Trump fiscal stimulus plan will push Treasury yields above current forward rates in 2017. Other bond markets will outperform in local currency terms, but will suffer losses via contagion from the U.S. Despite the dizzying amount of debt accumulated since the Great Recession, it does not appear that debt service will sink the economies of the advanced economies as the Fed continues to normalize U.S. monetary policy. Debt service will rise from a low starting point and the swing in interest payments as a percent of GDP is unlikely to exceed previous cycles on a 2-year horizon for a 100 basis point rise in yields. The level of the interest payments/GDP ratio should not exceed previous peaks in most cases. The picture is much more threatening if yields were to surge by 300 basis points over the next couple of years, although this scenario would require an unexpected acceleration of inflation in the U.S. and/or the other advanced economies. We are not making the case that the buildup of debt is benign. Academic research has linked excessive leverage with slower trend economic growth and a higher risk of financial crisis. For governments, elevated debt can result in a rising risk premium that will crowd out spending in important areas, such as health and pensions, in the long run. For consumers and the corporate sector, excessive leverage could result in financial distress and a spike in defaults in the next downturn, reinforcing the contraction in output. The Bank for International Settlements agrees: "Increased household indebtedness, in and of itself, is not likely to be the source of a negative shock to the economy. Rather the primary macroeconomic implication of higher debt levels will be to amplify shocks to the economy coming from other sources, particularly those that affect household incomes, most notably rises in unemployment." 4 Debt lies at the heart of BCA's longstanding Debt Supercycle thesis. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness for monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in private credit growth in the major developed countries because the starting point for leverage is already elevated. Growth headwinds finally appear to be ebbing, at least in the U.S., prompting the FOMC to begin the process of "normalizing" short-term interest rates. The U.S. economy could suffer another setback in 2017 for a number of reasons. Nonetheless, the key point of this report is that the cash-flow effect of rising interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Mark McClellan Senior Vice President The Bank Credit Analyst 1 For China, the BIS only provides an estimate of the debt service ratio for the household and non-financial corporate sectors combined. 2 See: U.S. Consumer Titanic Meets the Fed Iceberg? The BCA U.S. Fixed Income Analyst, July 2004. 3 The absence of a rise in volatility of the cash flow effect is partly due to the decline in, and the volatility of, interest rates after the 1980s. 4 Guy Debelle, "Household Debt and the Macroeconomy," BIS Quarterly Review, March 2004. Appendix Charts Chart II-16, Chart II-17, Chart II-18, Chart II-19 Chart II-16U.S. Debt By Sector Chart II-17U.K. Debt By Sector Chart II-18Japan Debt By Sector Chart II-19Euro Area Debt By Sector III. Indicators And Reference Charts Global equities have been in a holding pattern so far in 2017, consolidating the gains made at the end of last year. Our key equity indicators are mixed at the moment. The Valuation indicator continues to hover at about a half standard deviation on the expensive side. The effect of the rise in global equity indexes late last year on valuation was offset by a surge in profits. Stocks are not cheap but, at this level, valuation not a roadblock to further price gains. Our Monetary indicator deteriorated further over the past couple of months, driven by a stronger dollar and higher bond yields. A shift in this indicator below the zero line would be negative for stock markets. Sentiment is also frothy, which is bearish from a contrary perspective, although our Technical indicator is positive. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have all turned higher from a low level for the Japanese, the European and the U.S. markets. This suggests that investors, after loading up on bonds last year, have "dry powder" available to buy stocks as risk tolerance improves. The U.S. WTP has risen the fastest and is closing in on the 0.95 level. Our tests show that, historically, investors would have reaped impressive gains if they had over-weighted stocks versus bonds when the WTP was rising and reached 0.95. The WTPs suggest that the U.S. market should outperform the Eurozone and Japanese markets in the near term, although for macro reasons we still believe the U.S. will lag the other two. We expect the global stock-to-bond total return ratio to rise through this year. The latest selloff has pushed U.S. Treasurys slightly into "inexpensive" territory based on our Valuation model. Bonds are still technically oversold and sentiment remains bullish, suggesting that the consolidation phase may last a little longer. Nonetheless, we expect to recommend short-duration positions again once the overbought conditions unwind. The U.S. dollar is near previous secular peaks according to our valuation measure. Nonetheless, policy divergences are likely to drive the U.S. dollar to new valuation highs before the bull market is over. Technically overbought conditions have almost unwound, clearing the way for the next leg of the dollar bull run. Commodities have been on a tear on the back of improving and synchronized growth across the major countries (and some dollar weakness very recently). The commodity price outlook is clouded by the prospect of a border tax, which could send the U.S. dollar soaring. The broad commodity market is also approaching overbought levels. The cyclical growth outlook is positive for commodity demand, although supply factors favor oil to base metals. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And Earnings: ##br##Relative Performance Chart III-7Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst