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Highlights A resurfacing of trade tensions could weigh on risk sentiment in the near term. A somewhat less dovish tone from the FOMC this month could further rattle risk assets. While we would not exclude the possibility of an “insurance cut,” the Fed is probably uncomfortable with the amount of easing that markets now expect. That being said, a trade truce is still more likely than not, and while the Fed will resist cutting rates this year, it will not raise them either. The neutral rate of interest in the U.S. is higher than widely believed, which means that monetary policy will remain accommodative. That’s good news for global equities. Investors should maintain a somewhat cautious stance over the next month or so. However, they should overweight stocks, while underweighting bonds, over a 12-month horizon. The equity bull market will only end when U.S. inflation rises to a level that forces the Fed to pick up the pace of rate hikes. That is unlikely to occur until late-2020 at the earliest. Feature Stocks Bounce Back We turned positive on global equities in late December after a six-month period on the sidelines. While we have remained structurally bullish over the course of this year, we initiated a tactical hedge to short the S&P 500 on May 10th following what we regarded as an overly complacent reaction by investors to President Trump’s decision to increase tariffs on Chinese imports. Our reasoning at the time was that a period of market pressure would likely be necessary to forge an agreement between the two sides. Our thesis was looking prescient for a while. However, the rebound in stocks since last week has brought the S&P 500 close to the level where we initiated the trade. Is it time to drop the hedge? Not yet. First, market internals do not inspire much confidence. Even though the S&P 500 is just below its year-to-date (and all-time) high, the Russell 2000 is 5.1% below its May highs, and 11.8% below where it was last August (Chart 1). The S&P mid cap and small cap indexes are 6.8% and 16.2%, respectively, below their highs reached last August. Such weak breadth is disconcerting. Chart 1U.S. Stocks: Not As Strong As They Appear Second, President Trump’s decision to suspend raising the tariffs on Mexican imports may have had less to do with his desire to seek a more conciliatory tone, and more to do with pressure from Congressional Republicans. Various news reports suggested that Mitch McConnell and other Republican leaders opposed the action, and threatened to revoke the President’s authority to unilaterally impose tariffs.1 In the end, the deal with Mexico contained many of the same measures that the Mexicans had already agreed to implement months earlier. Our geopolitical team remains skeptical of a grand bargain in trade talks with China.2 In the United States, protectionist sentiment is politically more popular towards China than it is towards other countries (Chart 2). A breakthrough is still probable, but again, it may take a stock market selloff to produce a trade truce. Third, we have become increasingly concerned that the market has gotten ahead of itself in pricing in Fed easing. While we would not rule out the possibility that the Fed takes out an “insurance cut” to guard against downside risks to the economy, the 80 basis points of easing that the market has priced in over the next 12 months seems excessive to us. Chart 3Financial Conditions Have Not Tightened Much Unlike late last year, U.S. financial conditions have tightened only modestly over the past nine weeks (Chart 3). The economy is also performing reasonably well. According to the Atlanta Fed GDPNow model, real final sales to domestic purchasers3 are set to grow by 2.5% in the second quarter, up from 1.5% in Q1 (Chart 4). Real personal consumption expenditures are on track to rise by 3.2%. Gasoline futures have tumbled, which will support discretionary spending over the next few quarters (Chart 5). Chart 5Lower Gasoline Prices Should Bode Well For Discretionary Spending Granted, the labor market has cooled down. Payrolls increased by only 75K in May. However, the Council of Economic Advisers estimated that flooding in the Midwest shaved 40K from payrolls. And even with this adverse impact, the three-month average for payroll growth still stands at 151K, well above the 90K-to-100K or so that is needed to keep up with labor force growth. Meanwhile, initial unemployment claims remain muted and the employment component of the nonmanufacturing ISM hit a seven-month high in May. Chart 6Trimmed Mean PCE Inflation Back To 2% Inflation expectations are on the low side, but actual inflation is proving to be reasonably sturdy. The core PCE index rose by 0.25% month-over-month in April. Trimmed mean PCE inflation increased above 2% on a year-over-year basis for the first time in seven years (Chart 6). According to a recent Fed study, the trimmed mean calculation is superior to the core PCE index as a summary measure of underlying inflationary trends.4 Ultimately, the fact that the U.S. economy is holding up well is a positive sign for equity returns over the next 12 months. In the short term, however, it does create the risk that the Fed will sound less dovish than investors are anticipating, leading to a temporary selloff in stocks. Hence our view: near-term cautious, longer-term bullish. Who Determines Interest Rates? Central banks decide where rates will go in the short run, but it is the economy that determines where interest rates will go in the long run. The neutral rate of interest is the rate that corresponds to full employment and stable inflation. One can also think of it as the rate that aligns the level of aggregate demand with the maximum potential output the economy is capable of achieving without overheating. Both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral. But are they really? If a central bank keeps rates below their neutral level for too long, inflation will eventually break out, forcing the central bank to raise rates. Conversely, if a central bank raises rates above their neutral level, growth will slow, inflation will decline, and the central bank will be forced to cut rates. The problem is that changes in monetary policy typically affect the economy with a lag of 12-to-18 months. Inflation is also a highly lagging indicator. It usually peaks well after a recession has begun and troughs long after the recovery is under way (Chart 7). Thus, central banks have to make an educated guess as to where the neutral rate lies and try to steer the economy towards that rate in a way that achieves a soft landing. Needless to say, this is easier said than done. Today, both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral (Chart 8). Chart 8The Fed Thinks Rates Are Close To Neutral But are they really? That’s the million dollar question. Not only will the answer determine the medium-term path of interest rates, it will also determine how long the current U.S. economic expansion will last. Recessions rarely occur when monetary policy is accommodative, and equity bear markets almost never happen outside of recessionary periods (Chart 9). Thus, if rates are currently well below neutral, investors should maintain a bullish equity tilt. Chart 9Recessions And Bear Markets Usually Overlap Chart 10U.S.: Federal Fiscal Policy Has Been Expansionary Where Is Neutral? The neutral rate of interest is a function of many variables, most of which are not in the Laubach Williams model. Let us consider a few: Fiscal Policy A larger budget deficit boosts aggregate demand, while higher interest rates lower demand. Thus, once an economy has achieved full employment, an easing of fiscal policy must be counterbalanced by an increase in interest rates, which is another way of saying that looser fiscal policy raises the neutral rate of interest. The U.S. cyclically-adjusted budget deficit has risen by about 3% of GDP since 2015. Both tax cuts and increased federal discretionary spending have contributed to the deterioration in the fiscal balance (Chart 10). Standard “Taylor Rule” equations suggest that a 1% of GDP increase in aggregate demand will raise the appropriate level of the fed funds rate by 0.5-to-1 percentage points.5 This implies that easier fiscal policy has lifted the neutral rate of interest by 1.5-to-3 percentage points over the past five years. Labor Market Developments A tight labor market tends to increase the share of national income accruing to workers (Chart 11). Workers generally spend more of every dollar of income than businesses. Thus, a shift of income from businesses to workers raises the neutral rate of interest. The fact that a tight labor market usually generates the biggest gains for workers at the bottom of the income distribution – who have the highest marginal propensity to spend – further amplifies the positive effect on aggregate spending. Chart 11Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight The labor share of income has rebounded since reaching a record low in 2014. The lowest-paid workers have also seen the largest wage increases during the past 12 months (Chart 12). Neither of these nascent developments have come close to unwinding the beating that labor has suffered in relation to capital over the past four decades, but if the unemployment rate keeps falling, workers are going to start gaining the upper hand. Thus, one would expect the neutral rate of interest to rise further as the labor market continues to tighten. Credit Growth The Great Recession ushered in a painful deleveraging cycle. Household debt fell from 86% of GDP in 2009 to 70% of GDP in 2012. The household debt-to-GDP ratio has edged slightly lower since then due to continued declines in mortgage debt and home equity lines of credit. A return to the rapid pace of credit growth seen before the financial crisis is unlikely. Nevertheless, a modest releveraging of household balance sheets would not be surprising. Some categories such as student and auto loans have seen fairly robust debt growth (Chart 13). Housing-related debt could also stage a modest comeback due to rising home prices and buoyant consumer confidence. Conceptually, the rate of credit growth determines the level of aggregate demand.6 Thus, if household credit growth picks up at the margin, this would push up the neutral rate of interest. Corporate debt levels also have scope to rise further. Net corporate debt is only modestly higher than it was in the late 1980s, a period when the fed funds rate averaged nearly 10% (Chart 14). Chart 13U.S. Housing Deleveraging Has Slowed Chart 14U.S. Corporate Debt (I): No Cause For Alarm Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above, while the ratio of debt-to-assets is below, their respective long-term averages (Chart 15). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Almost every recession in the post-war era has begun when the corporate sector financial balance was in deficit (Chart 16). Chart 15U.S. Corporate Debt (II): No Cause For Alarm Chart 16U.S. Corporate Debt (III): No Cause For Alarm The Value Of The U.S. Dollar A stronger dollar reduces net exports. This drains demand from the economy, which lowers the neutral rate of interest. The real broad trade-weighted dollar index has risen 10% since 2014. According to the New York Fed’s econometric model, this would be expected to reduce the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative decline of 0.7%, equivalent to a decrease in the neutral rate of 0.35%-to-0.7%. The New York Fed model assumes an “all things equal” environment. All things have not been quite equal, however. The U.S. has benefited from a modest improvement in its terms of trade7 over the past five years (Chart 17). The shale boom has also significantly cut into oil imports. As a result, the trade deficit has fallen from 5.9% of GDP in 2005 to 2.9% of GDP at present. Chart 17The Dollar Has Appreciated Since 2014 Chart 18The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Asset Prices An increase in asset values – whether they be equities, bonds, or homes – makes people and businesses feel wealthier, which leads to more consumption and investment spending. As such, higher asset prices raise the neutral rate of interest. Today, U.S. household net worth stands near a record high as a percent of disposable income (Chart 18). The personal savings rate, in contrast, still stands at an elevated 6.4%. If the savings rate falls over the coming months, this would further boost aggregate demand. Demographics Slower labor force growth has led to a decline in trend GDP growth in the U.S. and most other economies. Slower economic growth tends to reduce the neutral rate of interest. The Bureau of Labor Statistics expects labor force growth to be broadly stable over the next 5-to-10 years, with immigration compensating for the withdrawal of baby boomers from employment (Chart 19). Chart 20Savings Over The Life Cycle In the current political climate, there is quite a bit of uncertainty over how many immigrants will settle in the United States. On the one hand, less immigration would reduce labor force growth, thus lowering the neutral rate. On the other hand, a decline in immigration would lead to an even tighter labor market, thus potentially raising the neutral rate. An additional question is how population aging, which will continue even if immigration remains elevated, will affect the neutral rate. Older people work less, but consume more than younger people, once health care spending is accounted for (Chart 20). If overall national output falls in relation to consumption, national savings will go down. This will raise the neutral rate of interest. The Shift To A Capital-Lite Economy Firms increasingly need less physical capital to carry out their activities. Larry Summers has labeled this the “demassification” of the economy. Lower investment spending would translate into a lower neutral rate. While plausible, it is not clear how important this phenomenon is. Companies may need less physical capital, but they need more human capital. Instead of more lending to businesses to finance purchases of machinery, we get additional lending to students. If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. The share of R&D and other intangibles in business investment has risen from around 14% in the 1960s to 33% today (Chart 21). Importantly, the depreciation rate for intangible investment is much higher than for other forms of capital spending. As intangible investment has increased, the overall depreciation rate for the economy has risen (Chart 22). Conceptually, an increase in the depreciation rate should lead to a higher neutral rate of interest.8 Chart 21A Larger Share Of Business Investment Is Intangible... Chart 22...And That Puts Upward Pressure On The Depreciation Rate Watch Housing And Business Capex The discussion above suggests that the neutral rate of interest is probably higher than widely believed. That said, there is significant uncertainty around any estimate of the neutral rate. As such, we recommend that investors track the more interest-rate sensitive sectors of the economy to gauge whether monetary policy is becoming restrictive. Housing, and to a lesser extent, business capital expenditures are the key indicators to watch. As a long-lived asset, housing is very sensitive to mortgage rates. Chart 23 shows that changes in mortgage rates tend to lead residential investment and home sales by about six months. Chart 23Housing Is Interest-Rate Sensitive If the decline in mortgage rates since last fall fails to spur housing, this would support the claim that monetary policy turned restrictive last year. Fortunately, the jump in homebuilder confidence, the outperformance of homebuilder stocks, and the surge in mortgage applications for purchases all suggest that the housing sector remains on firm ground (Chart 24). Despite the broad-based weakness in the global manufacturing sector, U.S. capex intentions remain reasonably buoyant (Chart 25). This week’s release of the May NFIB small business survey, which showed that the share of firms citing “now is a good time to expand” jumped five points to a seven-month high, provides further evidence in support of this view. Chart 24Some Positives For U.S. Housing Chart 25U.S. Capex Intentions Remain Solid A Two-Stage Fed Cycle Chart 26Inflation Expectations Are Not Where The Fed Wants Them To Be If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. Right now, the Fed has the luxury of time on its side. Even though some measures of core inflation such as the trimmed mean calculation discussed above have reached the Fed’s 2% target, this follows a prolonged period of below-target inflation. A few years of above-trend inflation would hardly be the worst thing in the world. The Fed’s failure to reach its inflation target has pushed long-term inflation expectations below the central bank’s comfort zone (Chart 26). Given the asymmetric risks created by the zero lower bound on interest rates - if inflation rises too fast, the Fed can always hike rates; but if inflation falls too much, it may be impossible to ease monetary policy by enough to avert a recession - the Fed can afford to remain patient. Thus, while the Fed is unlikely to cut rates as much as investors currently expect, it is also unlikely to raise them this year. Thanks to a cyclical revival in productivity growth, unit labor cost inflation has actually declined over the past 12 months (Chart 27). However, as we get into late next year and 2021, circumstances may change. If an increasingly tight jobs market continues to push up wage growth, unit labor costs will start to reaccelerate. Cost-push inflation will kick in. At that point, the Fed may have no choice but to pick up the pace of monetary tightening. All this suggests that Fed policy will evolve in two stages: an initial stage lasting for the next 12-to-18 months where the Fed is doing little-to-no tightening (and could even cut rates if the trade war heats up), followed by a second stage where the central bank is scrambling to raise rates to cool an overheated economy. U.S. Treasury yields are likely to rise modestly during the first stage in response to stronger-than-expected economic growth. We see the 10-year yield clawing its way back to the high-2% range by early next year. Yields could rise more precipitously, to around 4%, in the second stage once inflation begins to move decisively higher. The dollar is unlikely to strengthen during the first stage. Indeed, our baseline forecast calls for a period of modest dollar weakness stretching into late next year driven by a reacceleration in European and Chinese/EM growth. The sharp rebound in Chinese real estate equipment purchases from -18% on a six-month basis late last year to +30% in April suggests that the government’s stimulus efforts are working (Chart 28). Chart 27No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 28China: A Sign That Stimulus Is Finding Its Way Into The Economy The greenback will likely appreciate, perhaps significantly so, once the Fed picks up the pace of rate hikes in late 2020. The accompanying tightening in global financial conditions is likely to sow the seeds for a worldwide downturn in 2021. The combination of faster global growth and a weaker dollar will support global equities over the next 12 months. European and EM bourses will benefit the most. Investors should begin derisking in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Patricia Zengerle, “U.S. Lawmakers Seek To Block Trump On Tariffs,” Reuters, June 5, 2019. 2 Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019. 3 Final sales to domestic purchasers is equal to gross domestic product (GDP) excluding net exports of goods and services, less the change in private inventories. 4 Jim Dolmas and Evan F. Koenig, “Two Measures Of Core Inflation: A Comparison,” Federal Reserve Bank Of Dallas, Working Paper 1903, February 25, 2019. 5 Depending on which specification of the Taylor Rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor’s original specification) or by a full point (Janet Yellen’s preferred specification). John B. Taylor's 1993 specification is based on the following equation: rt = 2 + pt + 0.5(pt - 2) + 0.5yt. Janet Yellen's preferred specification is based on the following equation: rt = 2 + pt+ 0.5(pt - 2) + 1.0yt. Please note: For both specifications above, rt is the federal funds rate; pt is core PCE expressed as a year-over-year percent change; and yt is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook And Monetary Policy," April 11, 2012. 6 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 7 Ratio (multiplied by 100) of the price index for exports of goods and services to the price index for imports of goods and services. 8 The higher the depreciation rate, the more investment is necessary to maintain the existing capital stock. More investment demand for any given level of savings implies a higher interest rate. One can see this in the Solow growth model, which posits that the neutral rate of interest (r*) should be equal to: Where a is the output elasticity of capital, s is the savings rate, n is labor force growth, g is the growth in total factor productivity, and d is the depreciation rate. The equation implies that the neutral rate of interest will increase if capital intensity increases, the savings rate declines, the rate of labor force growth picks up, technological progress accelerates, or the depreciation rate increases. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Currency markets continue to fight a tug of war between weak incoming data but easier financial conditions. Our thesis remains that the path of least resistance for the dollar is down, but the rising specter of global market volatility suggests it could catapult to new highs before ultimately reversing. Most of our pro-cyclical trades have been put offside in this environment of rising volatility. Maintain tight stops until more evidence emerges that global growth has bottomed. Large net short positioning in the Swiss franc and yen, together with cheap valuations, make them attractive from a contrarian standpoint. Hold on to CHF/NZD positions recommended on April 26. Feature Our thesis remains that global growth is in a volatile bottoming process. However, incoming data pretty much across the globe has been very weak, with the latest specter of a global trade war suggesting that economic softness could linger for longer than we originally anticipated. Given the shifting market dynamics, it is important to revisit our thesis on how to be positioned in currency markets. We do so this week via the lens of the Australian dollar, one of the market’s favorite short positions. Future reports will focus on additional global growth barometers, and when to time the shift towards a more pro-cyclical stance. Positive Divergences Chart I-1Global Growth Barometers Flashing Amber On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices are breaking down after a nascent upturn earlier this year. One of our favorite indicators on whether or not easing liquidity conditions will lead to higher growth are the CRB Raw Industrials index-to-gold, copper-to-gold, and oil-to-gold ratios. It is disconcerting that these indicators have moved decidedly lower together with U.S. bond yields, another global growth barometer (Chart I-1). On a similar note, currencies in emerging Asia that sit closer to the epicenter of Chinese stimulus are breaking down. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working. Not surprisingly, the Australian dollar has been breaking down at a rapid pace, putting our long AUD/USD position offside. We will respect our stop-loss at 0.68 if breached, but a few indicators suggest the bearish view on the Australian dollar is very late: Chart I-2Australian Stocks Hitting New Highs Election Results: The recent general election outcome was a big surprise to the market, and has eased risks to both the country’s banks and housing market. The center-left Labour party, which moved further to the left in this electoral cycle, was defeated by a substantial margin. This has a few important implications. First, “negative gearing” – the practice of using investment properties that are generating losses to offset one’s income tax bill – will remain in place. This was a big overhang on the housing market, which likely exacerbated the downturn in Aussie house prices. Second, the capital gains tax exemption from selling properties will probably not be reduced from 50% to 25%, as previously pledged. Finally, the Liberal-National coalition government will maintain the policy of reimbursing investors for corporate taxes paid by the underlying company. This keeps the incentive for retirees to own high dividend-yielding equities such as those of Australian banks. Australian equities hit a new cyclical high following the election results. This suggests the return on capital for Aussie companies may have inched higher following the more pro-market leadership shift (Chart I-2). At low levels of interest rates, fiscal policy is much more potent than monetary policy. Interest Rates: The latest Reserve Bank Of Australia (RBA) minutes suggest that rate cuts are back on the agenda. But the question is, with the markets pricing in two rate cuts by the end of this year, does it still pay to be short the Aussie dollar on widening interest rate differentials? More importantly, fiscal policy is set to become decisively loose this year. The new government is slated to introduce income tax cuts as early as July. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Meanwhile, infrastructure spending will remain high, which will be very stimulative for growth in the short term. At low levels of interest rates, fiscal policy is much more potent than monetary policy, and the RBA will be loath to cut rates more than is currently expected by the market, at a time when consumer indebtedness remains quite high, and policy rates are already close to rock-bottom levels. The key for the RBA will be the job market, which at the moment remains a pillar of support for the Aussie economy. Job growth is accelerating, and labor force participation is hitting fresh highs (Chart I-3). So long as these trends continue, the RBA can afford to remain on the sidelines for a while longer. Meanwhile, while Aussie rates continue to drift downward, it has not been particularly profitable to buy U.S. Treasurys on a hedged basis (Chart I-4). Chart I-3Australia Employment Remains Robust Chart I-4It is Expensive To Short The Aussie Housing Market: For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities has rapidly morphed into a housing crash (Chart I-5). This is negative for consumption, both via the wealth effect and as well as for the outlook for residential construction activity. Chart I-5Could Australian Housing Bottom Soon? The good news is that policy is supposed to become supportive for Aussie homebuyers at the margin, with the government slated to introduce new initiatives to help first-time homebuyers. Should labor market improvements continue, it will also help household income levels. Over the past few decades, house prices in Australia have generally staged V-shaped recoveries when at this level of contraction. Betting on at least some stabilization going forward seems reasonable. Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. Admittedly, most measures of Chinese (and global) growth remain weak. However, there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these advance any further, they will begin to exceed GDP growth, indicating a renewed mini-cycle (Chart I-6). Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-7). Given that the reduction – if not the outright elimination – of pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost. Chart I-6Some Green Shoots From China Chart I-7Australian LNG Will Buffet Terms Of Trade Valuation: In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 15% from its 2018 peak, and 38% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-8). One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-9). Chart I-8Short AUD: ##br##A Consensus Trade Chart I-9AUD Is Attractive From A Terms Of Trade Perspective China Credit Cycle: We have discussed at length how a revival in the Chinese credit cycle will help global and Australian growth. On the real estate front, residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signaling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales have usually been in sync across city tiers. A revival in the property market will support construction activity and investment. Chart I-10How Long Will The Weakness In China Last? House prices have been rising to the tune of 10%-15% year-on-year, and may be sniffing an eventual pick-up in property volumes. Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufacturers cutting retail prices. This should help retail sales (Chart I-10). Other Global Growth Barometers Investors looking for more clarity on the global growth picture from the April and May data prints remain in a quandary. And the preliminary European PMI numbers this morning offered no glimmers of hope. That said, the most volatile components of euro area growth tend to be investment and net exports. Should they both pick up on the back of stronger external demand, GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently among the weakest in the euro zone. But forward-looking indicators suggest we may be on the cusp of a V-shaped bottom over the next month or so (Chart I-11). Chart I-11German Manufacturing Might Be At The Cusp Of A V-Shaped Recovery The broad message is that global growth is in the midst of volatile bottoming process. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data. We recommend maintaining a pro-cyclical bias at the margin, but having tight stop losses as well as positions in both the Swiss franc and yen as insurance. Housekeeping Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued at the time, the pound was sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit had significantly fallen. Since then, policy-induced volatility has led to a significant depreciation in the pound, with our position at risk of being stopped out at our 1.25 stop-loss this week. Given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-12). The CPI data this week confirm that the domestic environment is hardly deflationary. That said, given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. Chart I-12Hold GBP/USD, But Stand Aside At 1.25 Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: The Michigan consumer sentiment index jumped to 102.4 in May. However, the Chicago Fed national activity index fell to -0.45 in April. The Redbook index increased by 5.4% year-on-year in May. Existing home sales contracted by 0.4% month-on-month to 5.2 million in April. Moreover, new home sales fell by 6.9% month-on-month in April. The Markit composite index fell to 50.9 in April. The manufacturing and services PMI fell to 50.6 and 50.9 respectively. Importantly, this a just a nudge above the 50 boom/bust level. DXY index initially increased by 0.3%, then plunged on the weak PMI data, returning flat this week. The FOMC minutes released on Wednesday reiterated that the recent drop in core inflation is mostly transitory, and that no strong evidence exists for a rate change in either direction. With the forward market already pricing an 82% probability of a rate cut this year, any hawkish shift by the Fed will be a surprise. However, this will not necessarily be bullish for the dollar, if accompanied by a global growth bottom. We remain of the view that the path of least resistance for the dollar is down. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline consumer price inflation was unchanged at 1.7% year-on-year in April, while core inflation increased to 1.3%. The current account balance narrowed to a surplus of 24.7 billion euros in March. However, this was above expectations. German GDP was unchanged at 0.6% year-on-year in Q1. The euro area Markit composite PMI was flat at 51.6 compared to the last reading of 51.5. Below the surface, both the manufacturing and services PMIs fell to 47.7 and 52.5, respectively. German composite PMI was held up at 52.4 by the services component that came in at 55. However, the manufacturing component fell to 44.3. German IFO current assessment dropped to 100.6 in May, and the business climate dropped to 97.9. In France, the Markit composite PMI came in at 51.3. The manufacturing and services PMIs both increased, to 50.6 and 51.7 respectively. This was the one bright spot in euro area data. EUR/USD has been flat this week, with recent data being on the softer side. The PMI data remain subdued, in particular. Meanwhile, political uncertainties continue to weigh on investors’ sentiment. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Q1 annualized GDP grew by 2.1% quarter-on-quarter, well above estimates. Industrial production fell by 4.3% year-on-year in March, but was higher than the previous reading of -4.6% in February. Capacity utilization fell by 0.4% month-on-month in March. Exports contracted by 2.4% year-on-year in April, while imports increased by 6.4% year-on-year. The total trade balance thus narrowed from ¥528 billion to ¥64 billion. Notably, the exports to China fell by 6.3%, while exports to the U.S. increased by 9.6%. Machinery orders fell by 0.7% year-on-year in March. Nikkei manufacturing PMI fell below 50, coming in at 49.6 in May. USD/JPY fell by 0.5% this week. Yutaka Harada, a dovish member of the BoJ, warned during a news conference that by hiking the consumption tax rate at this critical juncture, Japan could risk sliding into a recession. With core CPI far from its 2% target, more monetary easing is probably exactly what the doctor ordered. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been firm: The Rightmove house price index increased by 0.1% year-on-year in May. The orders component of the CBI industrial trends survey decreased to -10 in May. Retail sales increased by 3% year-on-year in April. Producer prices and input prices increased by 2.1% and 3.8%, year-on-year respectively in April. Headline inflation and core inflation increased by 2.1% and 1.8% year-on-year in April, both below expectations. GBP/USD decreased by 0.6% this week. Teresa May offered MPs a vote on a second referendum on Brexit, which considers a tighter customs union with the EU. The ongoing Brexit chaos has increased volatility in the pound. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 117.2 this week. Westpac leading index fell by 0.1% month-on-month in April. Completed construction work fell by 1.9% in Q1. AUD/USD fell by 0.3% this week. During this week’s federal election, the coalition government led by Prime Minister Scott Morrison won. Besides the political development, the RBA governor Philip Lowe gave a speech on Monday, highlighting external shocks to Australian economy. He also expressed the positive outlook for Australian economy in the second half of 2019 and 2020, supported by the ongoing capex in infrastructure and resources sectors, together with strong population growth. More importantly, he mentioned that the RBA would consider the case for lower interest rates, which is a dovish shift from previous speeches. We are long AUD/USD with a tight stop at 0.68. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Credit card spending growth missed expectations, coming in at 4.5% year-on-year in April. Retail sales increased by 0.7% quarter-on-quarter in Q1. Retail sales excluding autos increased by 0.7% quarter-on-quarter in Q1. NZD/USD fell by 0.3% this week. NZD/USD is currently trading at a 7-month low around 0.65. A bleak external picture is worrisome for the kiwi. We continue to favor the AUD/NZD cross, from a strategic standpoint. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: Retail sales increased by 1.1% month-on-month in March. In particular, retail sales excluding autos increased by 1.7% month-on-month, well above estimates. USD/CAD appreciated by 0.3% this week. The better-than-expected retail sales data in March sparked a small rally in the loonie. However, the rally proved to be short-lived following softer oil prices. Positive data surprises in Canada will have to be sustained for the loonie to find some measure of support. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in the Switzerland have been positive: Money supply (M3) growth was unchanged at 3.5% year-on-year in April. Industrial production increased by 4.3% year-on-year in Q1, albeit lower than the last reading of 5.1%. USD/CHF fell by 0.8% this week. As we argued in last week’s research note, the increasing global market volatility has reignited interest in the Swiss franc. We continue to recommend the franc as an insurance policy amid rising geopolitical risk. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week: The unemployment rate came in at 3.5% in March, well below consensus of 3.7% and the previous reading of 3.8%. USD/NOK fell by 0.4% this week. Rising geopolitical risks will be supportive of the oil market and put a floor under the krone. Aside from the U.S.-Iran tensions, the world faces the prospect of the loss of Venezuelan production, and significant outages in Libya, which are all bullish. Meanwhile, Norway remains one of few G10 countries that can hike interest rates in the near term. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased by 0.5% in Q1. Moreover, the unemployment rate fell to 6.2% in April. This was well below expectations of 6.8% and the previous month’s reading of 7.1%. USD/SEK fell by 0.3% this week. While we favor both the NOK and SEK against the U.S. dollar, near-term factors are more bullish for the krone. Our long NOK/SEK position is currently 4.38% in the money. Stick with it. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Fed: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Economy: If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Strategy: Investors should keep portfolio duration low, avoiding the 5-year/7-year part of the Treasury curve. Investors should also overweight spread product versus Treasuries, with a focus on Baa and junk rated corporate bonds. Feature Since January, Federal Reserve policymakers have sent a strikingly unified message: Policy should remain “patient” in an effort to re-anchor inflation expectations and demonstrate the symmetry of the Fed’s 2 percent inflation target. Take for example, two excerpts from recent speeches by Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans. Rosengren:1 My own preference is for the Federal Reserve to adopt an inflation range that explicitly recognizes the challenge of the effective lower bound. We might be forced to accept below-2-percent inflation during recessions, but we would commit to achieving above-2-percent inflation in good times, so as to provide more policy space to counteract the next recession. Evans:2 I think the Fed must be willing to embrace inflation modestly above 2 percent 50 percent of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2 percent, as long as there is no obvious upward momentum and the path back toward 2 percent can be well managed. The consensus appears to be not only that higher inflation is necessary before the Fed lifts rates again, but also that the Fed should explicitly target an overshoot of its 2 percent target. With trailing 12-month core PCE inflation running at only 1.55% as of March, it will undoubtedly take some time before these inflation goals are met. We think the Fed’s commitment to keeping rates steady could waver if financial conditions ease sufficiently.3 But for now, with the market priced for 36 basis points of rate cuts over the next 12 months, the more pertinent question is: What will it take for the Fed to lower rates from current levels? Expecting A Rate Cut? Don’t Hold Your Breath Our Fed Monitor has an excellent track record calling turning points in monetary policy, and at present it is very close to zero, consistent with the Fed’s “on hold” stance (Chart 1). The Monitor is comprised of 44 indicators of economic growth, inflation and financial conditions. In other words, for the Monitor to recommend rate cuts going forward we will need to see some further deterioration in either economic growth, inflation or financial markets (Chart 2). This is roughly consistent with how Chicago Fed President Evans described his reaction function in his speech from two weeks ago: Chart 1"On Hold" Stance Justified Chart 2Fed Monitor Components If growth runs close to or somewhat above its potential and inflation builds momentum, then some further rate increases may be appropriate over time… In contrast, if activity softens more than expected or if inflation and inflation expectations run too low, then policy may have to be left on hold – or perhaps even loosened – to provide the appropriate accommodation to obtain our objectives. Our interpretation of the Fed’s reaction function is that it wants to maintain an accommodative monetary policy to ensure that inflation and inflation expectations move higher over time. However, it will consider monetary policy to be accommodative as long as GDP growth stays close to, or above, estimates of its potential rate. In other words, while the Fed is in no rush to tighten, we probably need to see a significant period of below-potential GDP growth before rate cuts are on the table. In his speech, Evans indicates that his personal estimate of potential GDP growth is 1.75%. The March Summary of Economic Projections shows that the central tendency of FOMC participant estimates is 1.8% - 2%. Our view is that U.S. growth will easily surpass this threshold in 2019, keeping rate cuts at bay. Tracking U.S. Growth Markets were caught off guard last week when we learned that real GDP grew 3.17% in the first quarter, above consensus estimates and well above the 1.8% - 2% potential growth threshold. However, the headline Q1 figure was flattered by significant gains in a few volatile GDP components. Chart 3Underlying Growth Slowdown Much like how core measures of inflation strip out volatile food and energy prices to give us a better sense of the underlying trend, we can also look at Real Final Sales To Domestic Purchasers (FSDP) to get a better sense of the underlying trend in economic growth. FSDP includes only consumer spending, nonresidential investment and residential investment. That is, it removes government spending, net exports and inventory investment from the overall number. Viewed this way, we see that the U.S. economy did experience a significant growth slowdown in the first quarter. Real FSDP grew only 1.45% in Q1, below the 1.8% - 2% potential growth threshold (Chart 3). Net Exports & Inventories Chart 4Net Exports & Inventories First quarter GDP was boosted by a +1.03% contribution from net exports and a +0.65% contribution from inventory investment, neither of which is likely to be repeated in Q2 (Chart 4). The top panel of Chart 4 shows just how unusual it is to see such a large contribution from net exports, an event that becomes even less likely when you factor in the dollar’s recent appreciation (Chart 4, panel 2). Turning to inventories, a significant build was long overdue given the backlog of orders seen during the past two years. But the ISM Manufacturing Index’s backlog of orders component has now fallen back to a neutral level (Chart 4, bottom panel). This suggests that firms are comfortable with their current inventory stockpiles, and that no aggressive inventory increases are likely during the next few quarters. Interestingly, while net exports and inventories will almost certainly pressure GDP growth lower in Q2, back toward the growth rate in FSDP, the latter has probably already troughed for the year. Recent data on consumer spending, nonresidential investment and residential investment all appear to have turned a corner. Consumer Spending Consumer spending added a meager +0.8% to GDP in Q1, but core retail sales growth has recovered sharply after having plunged near the end of last year (Chart 5). What’s more, with consumer sentiment close to one standard deviation above its historical mean – whether we look at expectations or current conditions surveys – consumers don’t seem inclined to retrench in the months ahead (Chart 6). Chart 5Consumer Spending Chart 6Buoyant Consumer Sentiment Nonresidential Investment Chart 7Nonresidential Investment We expected business investment to weaken in Q1, and its +0.4% growth contribution is low compared to recent readings. The decline was anticipated due to last year’s significant deterioration in global growth. Slower global growth necessarily causes firms to downgrade their profit expectations. Faced with lower expected profits, companies are much more inclined to curtail investment. However, considering the outlook heading into mid-year, we have already noticed signs of improvement in leading global growth indicators.4 More recently, we have even seen that improvement translate into stronger U.S. investment data. Core durable goods new orders grew +17% (annualized) in March, dragging the year-over-year rate up to +5.3% (Chart 7). Further, our BCA Composite New Orders Indicator – a weighted combination of ISM New Orders and NFIB Capital Spending Plans – has bounced during the past few months, returning close to its historical mean (Chart 7, panel 3). An average of Capital Spending Intentions from regional Fed surveys also remains close to one standard deviation above its historical average (Chart 7, bottom panel). Residential Investment Residential investment (aka Housing) has exerted a meaningful drag on GDP growth in each of the past five quarters, and it lowered GDP by -0.1% in Q1 (Chart 8). However, much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Optimism has returned to housing since mortgage rates fell earlier this year. New home sales and mortgage purchase applications have jumped, and single-family housing starts are the only important housing-related data that haven’t yet rebounded. We expect that rebound to occur soon, as do homebuilders whose confidence has risen during the past few months. Homebuilder optimism surveys remain close to one standard deviation above their historical averages (Chart 9). Chart 8Residential Investment Chart 9Buoyant Homebuilder Confidence Bottom Line: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Potential GDP growth is estimated to be in the 1.8% to 2% range. If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Implications To translate the above views on the economy and the Fed’s reaction function into a portfolio strategy, we first return to our Golden Rule of Bond Investing.5The Golden Rule states that if the Fed delivers more (fewer) rate hikes than are currently discounted in the market over the next 12 months, then the Treasury index will earn negative (positive) excess returns versus cash during that investment horizon (Chart 10). At present, this means that investors should only expect positive excess returns from taking duration risk in the event that the Fed cuts rates by more than 36 basis points during the next 12 months. Given our view that rate cuts are unlikely, investors should maintain below-benchmark portfolio duration. Chart 10The Golden Rule's Track Record If we further assume that market expectations will shift to price-in fewer rate cuts, or even possibly some rate hikes, then we would expect 5-year and 7-year yields to rise the most (Chart 11). Investors should avoid those maturities and focus their Treasury exposure on the short and long ends of the curve. These barbell over bullet trades have the advantage of being positive carry, so they will earn money even if rate hike expectations are unchanged.6 Chart 11Avoid The 5- And 7-Year Maturities Chart 12Investment Grade Spread Targets Finally, the combination of above-potential GDP growth and a patient Fed is positive for spread product. Investors should remain overweight spread product versus Treasuries in bond portfolios, focusing on Baa and junk rated corporate bonds. Spreads for those credit tiers remain wide compared to historical median levels for this phase of the cycle (Charts 12 &13).7 Chart 13High-Yield Spread Targets Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bostonfed.org/news-and-events/speeches/2019/monetary-policymaking-in-todays-environment.aspx 2 https://www.chicagofed.org/publications/speeches/2019/risk-management-and-the-credibility-of-monetary-policy 3 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 7 For further details on how we calculate these spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification