Policy
Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. CNYUSD may have some upside from current levels if the Trump administration applies only 10% rate to the second round of planned tariffs, but on balance is likely to come under further market pressure. This explains the PBOC's decision to try to support the currency. Interestingly, July brought some hopeful (albeit early) macro signals from China among the data that we track, some of which appear to have been overlooked by investors. Still, a neutral stance towards Chinese investable stocks versus the global benchmark continues to be warranted, at least until some clarity emerges about the magnitude and disposition of the export shock. Feature Economic and financial market conditions in China have not meaningfully improved since the publication of our last weekly report. Chart 1 highlights that China's economic surprise index remains in negative territory, and Chart 2 shows that Chinese investable and domestic stocks remain 22% and 29%, respectively, below their rolling 1-year high in local currency terms. In US$ terms, domestic Chinese stocks are 34% below their January peak, owing to the significant decline in CNYUSD. The BCA China Play Index and the relative performance of domestic infrastructure stocks versus global equities are two additional market indicators that we are watching closely as proxies for reflation, and neither is signaling a significant improvement (Chart 3). Chart 1Persistently Negative Economic Surprises... Chart 2...And Still In A Bear Market Chart 3Reflation Proxies Are Not Signaling A Major Economic Upturn The RMB Factor The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. While a weaker currency will actually help offset some of the export shock, Chart 4 shows that domestic stocks have not responded positively to the decline: the rolling 3-month correlation between the two has soared even further into positive territory over the past month, which may explain recent actions from the PBOC to help stabilize the currency. In short, the RMB appears to be acting as the "panic barometer" for domestic equity investors. Chart 4The RMB Is Acting As A "Panic Barometer" For Domestic Stocks Chart 5Some Evidence Of PBOC-Driven Depreciation The PBOC continues to maintain that it is not actively manipulating the RMB, arguing that both last year's appreciation and Q2's depreciation have occurred due to market supply and demand. Chart 5 casts some doubt on this claim, suggesting that at least some of the recent decline has been purposeful. The chart shows the standardized 1-month percent change in official reserves, measured in SDRs to help remove the impact of currency fluctuations. It highlights that the change in currency-neutral reserves has been quite elevated over the past three months relative to recent history, which is what would be expected (absent major capital outflow) if the PBOC was buying foreign currency assets to push down the exchange rate. But we agree that the extent of the decline is now probably more than what policymakers are comfortable with, which raises the question of how much more market-based pressure the RMB is likely to come under. In attempting to answer this question, it is interesting to note that the magnitude of the decline in CNYUSD over the past two months seems to have been closely aligned with the share of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 6 illustrates the magnitude of the decline in CNYUSD that would be implied by this framework in a variety of tariff scenarios. The chart shows that the RMB has some upside from current levels if the rate on the second round of tariffs is limited to 10% (instead of the 25% that has been threatened), and no additional tariffs are levied. But it also shows that further market pressure on the exchange rate is likely if the Trump administration simply follows through with their stated plans, and especially if the U.S. moves to tariff all imports from China. Notably, in the scenarios showing a further RMB decline, all of them fall below the psychologically important level of 7 yuan to the dollar. Chart 6More Pressure On RMB To Come If Trump Merely Follows Through With His Threats Given this, it is easy to see why investors feel that they are in limbo regarding the outlook for Chinese stock prices. They can observe the reflationary outlook of Chinese policymakers, but they are also factoring in: A looming export shock of still uncertain magnitude A strong signal from authorities that the campaign to control leverage and crackdown on shadow banking will not be abandoned Persistent RMB volatility An ongoing "old economy" slowdown that was already underway prior to the imposition of tariffs Domestic Economy Crosscurrents Chart 7Closely Watched Data Releases Negatively Surprised In July Concerning the last of these factors, we have written about a slowdown in China's old economy for the better part of the past year, a view that is now sharply in the market's focus given the negative external outlook. Last week's disappointing release of the July retail sales, industrial production, and fixed asset investment data certainly did not help improve investor sentiment towards China's economy (Chart 7). Interestingly, however, July did bring some hopeful (albeit early) macro signals from China, some of which appear to have been overlooked by investors. Table 1 presents the dashboard of select macro series that we have showed in several reports over the past few months. It highlights the evolution of the key six components of our BCA Li Keqiang index Leading Indicator, four housing market series that we have found to have strongly leading properties, as well as the NBS and Caixin manufacturing PMIs. Credit growth and the PMIs are currently providing the most negative signals, in that they declined in July and are below their 12-month moving average. In the case of credit growth, this is a continuation of an almost 2-year downtrend, but the PMI weakness has been much more recent (in response to the worsening export outlook). But several indicators that we track ticked up in July, including 4 out of 6 components of our leading indicator for the Li Keqiang index (LKI). The fact that monetary conditions indexes have risen should not be surprising given the recent weakness in the currency, but growth in the money supply also ticked up non-trivially last month (possibly due to the PBOC's apparent manipulation of the RMB). In the case of M2, the tick up technically pushed the YoY growth rate (modestly) above its trend for the first time in 2 years. Table 1Some Hopeful Signs, But Credit Remains Weak There are two other points from Table 1 worth highlighting, the first of which is negative. While the LKI itself has looked reasonably strong over the past few months (in contrast to our slowing domestic demand view), it ticked down in July for the second time. In addition, the LKI has recently been propped up by two, presumably unsustainable, factors: a spurt of rail cargo volume growth that appears to be strongly linked to trade front-running in advance of the U.S. import tariffs, and a surge in electricity consumption from the services industry (which is not investment-intensive). Chart 8 controls for the second factor by presenting an alternative measure of the LKI that replaces overall electricity production with consumption in primary and secondary industries; the difference in the recent trend between the two measures is clear. Chart 8The LKI Is Being Held Up By Trade Front Running And Services The second important point from Table 1 is positive: both housing starts and sales accelerated very significantly in July, with sales being particularly notable. BCA's China Investment Strategy service has highlighted that the housing sector represented the best candidate for meaningful acceleration in Chinese economic activity, and the July data was particularly impressive. It remains unclear whether the authorities will continue to follow through with a crackdown on the property sector, despite recent statements suggesting they will: household leverage is not enormously elevated relative to GDP, but it has accelerated very significantly over the past couple of years. But if the recent strength in sales volume continues and policymakers do not respond aggressively with macroprudential measures, our conviction in a sustained residential construction boom in China would rise materially. This will be important for investors to monitor, as it could provide a critical source of investment-driven domestic demand over the coming 6-12 months. Investment Conclusions Despite the crosscurrents buffeting China's economic outlook, we can draw three conclusions that lead us to firm near-term investment strategy recommendations: Market proxies are not signaling that Chinese policymakers will end up overstimulating the economy For now, credit growth, and the domestic "old economy" more generally, continues to decelerate Further RMB weakness may be in the cards To us, these conclusions clearly argue for a neutral stance towards Chinese investable stocks versus the global benchmark, at least until some clarity emerges about the magnitude and disposition of the export shock. We also continue to recommend that investors favor low market beta sectors within the investable universe, such as classical defensives as well as industrials.1 In early-July, we opened a "shadow" trade of being long the MSCI China A Onshore index / short MSCI China index, which we said we would consider implementing in response to a 5% rally in relative dollar performance. Chart 9 highlights that this threshold has not yet been reached, and we continue to warn against trying to catch a falling knife. But Chart 10 underscores how stretched (to the downside) domestic stocks have become: versus the global benchmark, relative stock prices in US$ have fallen to an 11-year low. Panel 2 illustrates that this stretched performance is at least in part driven by the performance of U.S. equities, but domestic stocks prices are still at the very low end of their post-GFC range when compared with global ex-U.S. stocks. Chart 9Still Too Early To Buy A-Shares... Chart 10...But The Selloff Seems Extremely Late In short, the potential for a substantial bounce in relative domestic equity performance is considerable were the economic outlook to stabilize, and we will be watching closely for an opportunity to time a reversal. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Investable industrial stocks in China have become relatively low-beta, owing to the fact that they had already materially underperformed the investable benchmark prior to the emergence of trade frictions with the U.S. Cyclical Investment Stance Equity Sector Recommendations
Highlights EM, The USD & Bond Yields: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Feature It's All About The Dollar Chart of the WeekBad Things Happen More Often With A Rising USD The turmoil in Turkey and collapse of the lira has been the latest bout of financial market turbulence seen in 2018. From the VIX shock in early February, to the Italy yield spike in May, to the bear market in Chinese equities, there have been big market meltdowns that seem to come out of nowhere. Yet these are not isolated events. The slowing pace of bond buying by the European Central Bank and the Bank of Japan, in addition to the Fed unwinding its huge balance sheet, have left the global financial system with diminished liquidity. More importantly, the Fed's tightening cycle has turned the U.S. dollar from a weak currency in 2017 to a strong currency in 2018 (Chart of the Week). Yes, U.S.-China trade tensions have compounded matters by raising uncertainties about global growth, but tightening monetary policies and more growth uncertainties have been the true cause of this year's market shocks. Turkey and Italy were questionable credits in 2017, but investors did not care when the dollar was soft and global growth was accelerating. Looking ahead, the key variable to watch will be the U.S. dollar. Many of BCA's strategists have made comparisons between the backdrop today and the late 1990s period that resulted in the 1998 Asian Crisis.1 Those comparisons are valid, given the high level of dollar debt in the emerging markets at a time of Fed tightening and a rising U.S. dollar (Chart 2). A key difference is that, in that late 1990s episode, the Fed was keeping U.S. monetary policy very tight as evidenced by the inverted U.S. Treasury yield curve and a fed funds rate that was well in excess of inflation (and well above what we now know to be the neutral r-star rate). The dollar surged during that period because global growth differentials strongly favored the U.S. Today, the Fed has not yet pushed the funds rate into restrictive territory and the dollar is still well below the peak seen in the late 1990s. With the Fed still not signaling any adjustment to its rate hike plans based on the latest bout of EM turmoil, there is scope for the dollar to continue appreciating over the next 6-12 months. The critical factor that could change this dynamic, however, is the pace of dollar appreciation. The U.S. trade-weighted dollar is now only 5% above the levels of a year ago. Looking back at the 2014/15 surge in the dollar, the peak annual pace of dollar appreciation reached 15% in mid-2015 (Chart 3). That move was big enough, and fast enough, to trigger a sharp U.S. economic growth slowdown, a contraction in U.S. corporate profit growth and a large fall in U.S. inflation (admittedly, helped by collapsing oil prices). It would take a 10% appreciation from current levels (think EUR/USD at 1.04) over the next four months to generate an equivalent pace of dollar appreciation (the black dotted line in all panels). So far, the EM turmoil and dollar strength have not resulted in much turbulence in U.S. financial markets (Chart 4). Corporate credit spreads have stayed well behaved, while U.S. equities are only modestly off the recent highs. Only U.S. Treasury yields have dipped lower from recent highs, even though yields are still contained within the range of the past few months. This is in sharp contrast to the 2015 episode, when U.S. financial markets eventually succumbed to the pressure of the strong dollar and EM selloff - but not without decisive evidence of slowing U.S. growth (top panel). Only then did the Fed finally capitulate and announce a pause after lifting rates just once at the end of 2015, sending Treasury yields sharply lower. Chart 2It's Not 1998##BR##...Yet Chart 3The Pace Of USD Appreciation##BR##Matters A Lot Chart 42015 Redux? Watch##BR##U.S. Growth & Earnings Until there is evidence that the U.S. economy is losing momentum, and that the stronger U.S. dollar and emerging market volatility are a root cause of slowing growth, global bond yields are unlikely to fall much lower on a sustainable basis. The next few readings on the ISM indices, employment growth and small business confidence, along with the third quarter earnings reports starting in October, will be critical in determining if the U.S. economy is falling victim to the "EM Flu". It will likely take more dollar strength before that happens, however. In the meantime, we continue to recommend a below-benchmark overall duration stance, with only a neutral allocation to global corporate bonds versus government debt. We still favor U.S. corporate debt over non-U.S. equivalents until there is evidence of slowing U.S. growth. Bottom Line: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Still Too Much Uncertainty For Rate Hikes One of our highest conviction calls since the start of 2018 has been to stay overweight Australian government bonds. The logic behind the view was simple; it would be very difficult for the Reserve Bank of Australia (RBA) to deliver even a single rate hike over the course of the year. A combination of a fragile consumer, persistent slack in labor markets and softening Chinese demand for Australian exports would all conspire to restrain Australian inflation and keep the RBA on the sidelines. So far, our view has largely come to fruition, to the benefit of Australian government bond performance. Chart 5Massive Australian Bond Outperformance vs USTs The RBA has held the benchmark Cash Rate at the same 1.5% level that has prevailed since August 2016. This has helped the Bloomberg Barclays Australia Treasury index deliver a local currency total return of 2.68% year-to-date. The performance has been even more impressive hedged into U.S. dollars, with an excess return over U.S. Treasuries of 3.95% - surpassing the overall Global (ex U.S.) Treasury index excess return by 85bps. The benchmark 10-year Australian yield has fallen 10bps since the end of 2017, in sharp contrast to the 46bps increase in the 10-year U.S. Treasury yield, with the spread between the two bonds now in negative territory for the first time since 1998 (Chart 5). Obviously, the potential for further outperformance of Australian bonds is diminished after such an impressive run. The Australian Overnight Index Swap (OIS) curve is now only discounting a mere 15bps of rate hikes over the next twelve months, and a move to outright rate cuts will be difficult with the economy still growing above trend and inflation now back to the low end of the RBA's 2-3% target range. Headline unemployment is now down to 5.4%, the lowest level since 2012 and within hailing distance of the 5% level that the RBA believes to be full employment. Yet there are now enough uncertainties regarding the Australian economic outlook to suggest that Australian government bonds should continue to outperform developed market peers over the next 6-12 months. The Biggest Uncertainties: Consumer Spending, Housing & Banks Consumer spending - 60% of Australian GDP, the largest component - has struggled to gain much positive momentum in recent years. Since the end of 2013, the year-over-year growth rate of real consumption has ranged between 2.2% and 3.1%. The lack of spending power has been the biggest problem, with real wage growth averaging a mere 0.2% over the past five years and hours worked remaining stagnant (Chart 6). Anemic income growth means that the household saving rate had to fall from 8% to 2% just to maintain an uninspiring 2.5% average pace of real consumer spending. Both real wage growth and average weekly hours worked have decelerated since the start of 2017, with the former now only at 0.1% and the latter at an all-time low. This has compounded the biggest structural risk to the Australian consumer - high debt. Household debt is now up to a record 190% of disposable income, the fourth highest figure among OECD countries after having shot up thirty percentage points since the end of 2012 (bottom panel). The ability to carry that huge debt load is helped by low interest rates that have helped keep debt service ratios in line with long-run averages. More recently, house prices have been coming off the boil (Chart 7). National house prices were down 2.5% in July on a year-over-year basis, led by declines in the major markets of Sydney (down 5.5% from the July 2017 peak) and Melbourne (down 3% from the November 2017 peak). In the RBA's latest Statement on Monetary Policy released earlier this month, it was noted that even such a modest decline in housing values after years of substantial price gains could have an outsized impact on overall consumption if focused on the more highly indebted or credit-constrained households.2 Yet a cooling of overheated housing values is, as RBA Governor Philip Lowe noted in a speech last week, a "welcome development" after years of unsustainable price gains that greatly diminished housing affordability.3 Homebuyer sentiment and growth in housing approvals have already ticked up in response to the slowing pace of house price appreciation, although both remain well below levels seen during the boom years. One wild card that could short-circuit any rebound in house prices is the availability of credit from Australian banks. The entire Australian banking industry has come under harsh criticism from the findings of the government's Royal Commission on Misconduct in the Banking, Superannuation and Financial Services Industry.4 The Commission was established at the end of 2017, after years of public pressure regarding the questionable business practices of Australian financial firms. Evidence of bribery, forged documents, extending loans to those that could not afford it and even charging fees to dead clients has already come to light. With financial firms on the defensive, there is a risk that banks will raise lending standards for new loans going forward. Australian bank equities have already been underperforming and credit growth is slowing (Chart 8). The bigger concern is the sharp decline in bank deposit growth, which is now contracting modestly on a year-over-year basis. Already, Australian banks are facing some higher funding costs through rising money market rates. Much of that spike seen earlier in 2018 could be attributed to rise in the U.S. bank funding costs, but there is now a notable divergence between LIBOR-OIS spreads in Australia and the U.S., which may be a sign of uniquely Australian funding pressures. Chart 6Poor Fundamentals For##BR##The Australian Consumer Chart 7Weaker Prices =##BR##Stronger Housing Demand? Chart 8An Australian Credit##BR##Crunch Unfolding? The RBA has noted that the absolute levels of bank funding costs (bank debt spreads, deposit rates wholesale lending rates) remain low by historical standards, and that overall financial conditions remain supportive for Australian economic growth. Yet the marginal changes in funding dynamics, combined with the pressure on banks to be more prudent in extending loans, raise downside risks to Australian growth from future credit availability. Other Uncertainties: Capital Spending, Exports & Commodity Prices Australian businesses have ramped up capital spending over the past year, with the annual growth rate of machinery and equipment investment now at the fastest pace since 2012 (Chart 9). An improvement in Australian commodity prices and the overall terms of trade has helped boost corporate profits, helping to fund investment spending. Importantly, the recent pickup in commodity prices has been more broad-based than the iron ore boom in 2010/11, with prices of non-ferrous metals rising even with iron ore prices languishing. Looking ahead, there are increasing risks to the capital spending upturn from growing uncertainties surrounding the outlook for Chinese economic growth, and global trade activity more generally. The NAB business confidence survey, which leads capital spending intentions, has been falling over the past several months (bottom panel). This comes after a significant slowing of Australian export growth, the manufacturing PMI and capacity utilization (Chart 10). Much of that is due to diminished demand from China, which remains Australia's largest export market. Chart 9Capex Upturn At Risk From Global Trade Tensions Chart 10China Is A Big Source Of Uncertainty In Australia China is now undertaking some fresh economic stimulus in response to the growing trade war with the U.S. and the imposition of tariffs. Our colleagues at BCA's China Investment Strategy and Geopolitical Strategy recently penned a Special Report discussing the potential for China's stimulus measures to halt the Chinese growth deceleration seen so far in 2018.5 Their conclusion was that the overall size of the stimulus would be significant, with the surge in fiscal spending potentially equaling the 3% GDP boost seen in 2015/16. This would help support Australia export demand, on the margin, and could potentially boost the prices of Australia's key industrial commodities. However, the overall impact will be less than was seen in 2016/17 given that there will be some offsetting drag from the imposition of tariffs by China and the U.S. The Most Important Uncertainty: How Much Spare Capacity? Chart 11Still Lots Of Slack In The Australian Economy Given all these potential headwinds to Australian growth, the RBA has stated that they are in no hurry to raise interest rates, particularly without any serious threat of an acceleration in inflation. Headline Australian CPI inflation rose to 2.1% in the second quarter of 2018, while core inflation drifted down to 1.8%. Both measures have struggled to breach the lower bound of the RBA's 2-3% target range in recent years (Chart 11). The biggest reason for this is the continued existence of spare capacity in the economy. The IMF estimates that Australia will have a negative output gap of nearly -1% in 2018, unlike most other developed economies where the gap has been closed. Overall wage inflation remains modest, as discussed earlier. While the headline unemployment rate of 5.4% is below the IMF's estimate of the full employment NAIRU of 5.9% (middle panel), the RBA thinks NAIRU is closer to 5%. That implies that there is still slack in the labor market, which is evidenced by the high level of underemployment and the growing share of part-time employment (bottom panel). The RBA anticipates that full employment will not be reached until the end of 2020, even with real GDP growth expected to average 3.25% over the next two years. Both headline and core inflation are projected to rise only to 2.25% by the end of 2020, staying in the lower half of the RBA target band. Unsurprisingly, the RBA has provided guidance stating that it does not expect to raise the Cash Rate before then. Investment Conclusions The Australian OIS curve has now priced out much of the nearly 50bps of rate hikes that were discounted at the start of the year, but there are still 15bps of rate increases expected over the next twelve months. Yet our own Australia Central Bank Monitor has now flipped into negative territory, indicating that fundamental economic and inflation pressures are pointing to the RBA's next move being a rate cut (Chart 12). While that is not our expectation, we think the argument that supported our original investment thesis on Australian government bonds at the beginning of 2018 still holds. Growth uncertainties, ample spare capacity and moderate inflation pressures will ensure that the RBA will struggle to deliver even a single rate hike in 2018 or 2019. Chart 12Stay Overweight Australian Government Bonds The main risk to our view would come from a bigger-than-expected stimulus from China and/or a resolution of the U.S.-China trade war. This would boost Australian economic growth and commodity prices and potentially bring forward the timing of the next RBA hike. We continue to recommend an overweight stance on Australian government bonds in global fixed income portfolios. All positions should be run on a currency-hedged basis, as the Australian dollar is likely to remain under downward pressure from less supportive interest rate differentials. For dedicated Australian bond investors, we recommend a neutral duration stance, as we see yields broadly following the path laid out in the forwards. Bottom Line: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17th 2018, available at fes.bcaresearch.com and gps.bcaresearch.com. 2 https://www.rba.gov.au/publications/smp/2018/aug/pdf/statement-on-monetary-policy-2018-08.pdf 3 https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-17.html 4 https://financialservices.royalcommission.gov.au/Pages/default.aspx 5 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The Turkish economy is in disarray, ... : The lira's plunge has reminded some investors of the Thai baht's in 1997, but we do not foresee a replay of the Asian Crisis. ... highlighting emerging markets' vulnerability to external factors: EM economies may be on firmer footing than they were 20 years ago, but the vicissitudes of dollar-denominated debt remain their Achilles' heel. Fraught times around the world justify paring back portfolio risk, ... : Increased caution is appropriate in the face of potential EM distress. Multiples are elevated and spreads are tight, leaving stocks and bonds susceptible to a pickup in risk aversion. ... even if domestic data indicate that the U.S. expansion is alive and well: Global concerns did nothing to dim small businesses' rosy outlook, but the dirty little secret within the July NFIB survey is that rising cost pressures will keep the Fed from backing off of its tightening plans. Feature Dear Client, This is our final report for the month of August. We will resume our regular publication schedule the first week of September. We wish everyone an enjoyable rest of the summer. Best regards, Doug Peta, Chief U.S. Investment Strategist What a difference a year makes. If 2017 was all about synchronized global growth, 2018 has been a study in desynchronization. While the list of sputtering international economies grows longer with every passing month, the U.S. economy continues to gather steam. The fact that it is leaving the laggards choking on its exhaust as it speeds by, trampling the conventions of the postwar international order the U.S. itself established, and tightening the screws on dollar borrowers, is bruising feelings from Ankara and Beijing to Ottawa and Brussels. There is nothing on the horizon to indicate that the desynchronization trend is about to end. Surreal as it may be for baby boomers and other pre-millennials, trade barriers are an essential plank in the Republicans' midterm election platform. Our geopolitical strategists caution that there is little reason to expect the anti-trade rhetoric out of Washington to die down before November. The associated headwinds for multinational corporations and economies more reliant on global trade are likely to persist for at least a few more months. The other global policy irritant comes from the Fed. Although it is not blind to the impact of its policies on other economies, its America First mandate is firmly entrenched. Confronted with a domestic economy that is being force-fed stimulus when it is already showing signs of bumping up against supply constraints, the Fed has very little room to relax its vigilance. Investors counting on an "EM put" to alter the course of rate hikes should recognize that that put is way out of the money: it will take a great deal of EM pain for the Fed to back away from its projected course. Turkey's Tenuous Model Before the Asian Crisis, the growth of the Asian Tiger economies was the envy of the world. The formula was simple and effective: take ample supplies of cheap labor, mix with developed-world capital to finance a buildup of manufacturing capacity, and watch eye-popping growth ensue. All was well until too much excitement led to hard-currency-debt-financed investment in overcapacity. When exchange-rate pegs fell, domestic borrowers became unable to meet their obligations and the Asian Miracle imploded. The Turkish lira's plunge has put many investors in mind of the Thai baht's 1997 collapse that set the Asian Crisis in motion. The EM contagion eventually found its way to Russia in the summer of 1998, felling hedge fund titan Long-Term Capital Management (LTCM) and thoroughly rattling several of its Wall Street enablers. Investors would be foolish to ignore the problems in Turkey, which could well ripple out into other EM economies and the developed world. However, our current base-case scenario does not call for anything on the order of the Asian Crisis. Chart of the WeekTurkey Is A Clear Outlier Today ... Chart 2... But It Would Have Been In The Thick Of Things In 1997 Turkey's dependency on external capital flows is reminiscent of the Asian Tigers', but it is an outlier in today's more conservative context (Chart of the Week). On the eve of the Asian Crisis, Turkey's external financing profile, on both a flow (current-account balance as a share of GDP) and a stock (external private debt as a share of GDP) basis, would have placed it squarely within the smart set (Chart 2). In retrospect, the Asian Miracle template of the early and mid '90s was an accident waiting to happen. Currency pegs are seen as a naïve relic, and exporters assiduously build up reserve war chests to prevent currency panics from taking root. Chart 3U.S. Banks Have Modest EM Exposure The key issue for U.S. investors is the potential for contagion to the U.S. banking system and its markets. It is almost impossible to identify an LTCM in advance, but the fact that the banking system is on a much tighter leash following the crisis means that it is far less vulnerable than it was in the late '90s. As our f/x strategists point out,1 European banks (especially Spain's BBVA) have considerably more exposure to Turkey and other fragile EM economies (Chart 3). Sentiment is the most likely transmission mechanism, and U.S. assets would seem to be last in line for multiple de-rating and spread widening, given the strength of the U.S. economy and its comparative remove from the rest of the world. Bottom Line: The magnitude of Turkey's financing excesses is not representative of the entire EM complex. U.S. investors should operate with a heightened sense of caution, but they should not panic. Emerging Markets' Achilles' Heel The magnitude of Turkey's reliance on external financing is unusual, but the direction is common. The vast bulk of the world's wealth is held in developed economies, and EM projects necessarily source capital from DM investors. Over 90% of all EM corporate debt is denominated in hard currency, of which the vast majority is denominated in U.S. dollars. For EM corporates with mainly domestic revenues, moves in the dollar exchange rate exert disproportionate influence over how comfortably they can service their debt. Exchange rates are determined by many factors, but real interest rate differentials are among the most prominent drivers. When the Fed hikes the fed funds rate while other central banks are easing policy or standing pat, the dollar tends to appreciate. A rising dollar pressures EM corporate borrowers, and hasn't been good for EM stock prices, either (Chart 4). If the Fed were to lift the fed funds rate all the way to 3.5% by the end of 2019, as we expect, several EM borrowers could find themselves in the crosshairs. Chart 4Tighter Fed Policy Squeezes EM Equities, Too Meaningful Chinese stimulus could go a long way to offsetting Fed tightening pressures. A more robust Chinese economy would trade more and consume more natural resources. Increased export volumes and higher commodity prices would boost EM exports and commodity prices, helping to support exchange rates. Unfortunately for Asian and Latin American EMs, the jury is still out as to whether or not the Chinese cavalry will ride to the rescue. Our China strategists have observed that a sizable stimulus injection would run counter to policy makers' commitment to reining in shadow banking excesses and cooling off the property market. If the trade war with the U.S. really starts to bite, however, reform may become a lesser priority. The powers that be have been circumspect with stimulus so far (Chart 5), weakening the currency to defend exports (Chart 6) rather than attempting to boost domestic activity via government spending. We will keep a close eye on Chinese policy developments as they unfold. Chart 5Instead Of Helping The EM Bloc With Reflation,... Chart 6...China Has Been Exporting Deflation Bottom Line: Chinese stimulus could help cushion the blow from a stronger dollar, but policy makers have yet to show their hand. Stay tuned. The View From Main Street Despite the global challenges, the July NFIB survey underlined the point that the U.S. economy is flying high. The headline Optimism Index is a single tick below its all-time high (Chart 7, top panel), the Hiring Plans (Chart 7, second panel) and Job Openings components (Chart 7, third panel) are at or near all-time highs, and the Good Time to Expand component is just off the high it set in May (Chart 7, bottom panel). All in all, the view from Main Street is the best it's ever been over the survey's 44-year history. All of the readings in Chart 7 are so good (two-plus standard deviations above the mean), that there is little scope for improvement. Mean reversion may well begin to assert itself, but it is likely to be a slow process. Overall optimism peaks well ahead of downturns, and tends to take its time deteriorating. It lends support to the message from our recession indicator2 that the expansion has at least another year to run. All good things come to an end, however, and the downside to the gangbusters survey results is that they foreshadow the expansion's eventual demise. Respondents' reports of price changes and future intentions to raise them correlate closely with PCE inflation (Chart 8). Record strength in job openings and hiring intentions indicates the labor market is tight enough to squeak, suggesting that firms will soon have to bid up wages to attract new employees. Taken together, the inflation-related measures imply that the Fed will not be able to let up, supporting the house view that the fed funds rate will surprise to the upside. Chart 7A Roaring Economy... Chart 8...Carries The Seeds Of Its Own Demise Bottom Line: The end of the expansion is not at hand, but its strength will eventually compel the Fed to step in to cut it off. Investment Implications Fiscal stimulus and monetary policy still support the expansion and the bull markets in equities and corporate debt, but they will not do so indefinitely. Stimulus is not sustainable from a budgetary standpoint, and gathering inflationary pressures will eventually inspire the Fed to wield its policy tools to bring the curtain down on the business cycle. The shift to restrictive policy will mark an inflection point in risk-asset performance, and investors should pursue more defensive portfolio positioning when it arrives. Although the cyclical inflection point is not yet upon us, the uncertain outcome of trade tensions and emerging market vulnerabilities merit dialing back portfolio risk in the near term. In line with the BCA house view, we recommend overweighting cash and underweighting bonds, while maintaining benchmark positioning in equities. Treasuries will likely outperform if the EM rumblings turn into something more serious, but we would view any decline in yields as a temporary respite from a Treasury bear market that has already been in place for two years. Depending on when, or if, the current global pressures abate, the equity bull market may still have some juice, and we are keeping an open mind about moving stocks back to overweight for the final push. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 17, 2018 Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers," available at fes.bcaresearch.com. 2 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.
Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Chart 4U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.
Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Chart 2Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification