Asset Allocation
Highlights Investors are too complacent about the risks of a trade war. Standard economic models understate the potential economic damage that a trade war could cause. Global equities would suffer mightily from a trade war. Deep cyclical sectors would be hardest hit. Financial equities would also fare poorly. Regionally, European and EM stock markets would underperform. A trade war would benefit Treasurys and other safe-haven government bonds. A contained trade war would likely be somewhat dollar-bearish. In contrast, a full-out war could send the greenback soaring. Feature From Phony War To Real War? After months of posturing, Trump's trade war is starting to heat up. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion of goods are set to go in effect on July 20th. China has stated that it will retaliate in kind. On Tuesday, Trump further upped the ante, announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year! China is not the only country in Trump's crosshairs. The Trump administration levied tariffs of up to 25% on steel and aluminum from the EU, Canada, Mexico, and other U.S. allies on June 1, 2018. The affected regions have retaliated with their own tariffs. As Marko Papic, BCA's chief geopolitical strategist, has repeatedly stressed, there is little reason to think that trade tensions will ease over the coming months. Protectionism is popular with the American public (Chart 1). Trump ran on a protectionist platform and now he is trying to fulfill his campaign promises. It does not help that Trump is accusing foreign governments of doing things they are not doing. Chart 2 shows that U.S. tariffs are actually higher than in most other G7 economies. As we have argued in the past, the U.S. runs a persistent current account deficit because it has a higher neutral real rate of interest - otherwise known as r-star - than most other countries.1 Standard interest rate parity equations imply that a country with a relatively high neutral rate will have an "overvalued" currency that is expected to weaken over time, whereas a country with a low neutral rate will have an "undervalued" currency that is expected to strengthen over time. Intuitively, this must happen because investors will only hold low-yielding bonds if they expect a currency to strengthen. The result is a current account deficit for countries with overvalued currencies such as the U.S., and a current account surplus for regions with undervalued currencies such as the euro area (Chart 3). Chart 1Free Trade Is Not In Vogue In The U.S. Chart 2Tariffs: Who Is Robbing The U.S.? Chart 3Interest Rates And Current Account Balances The Economic Costs Of A Trade War How much damage could a trade war do to the global economy? As it turns out, this is a surprisingly difficult question to answer. Standard economic theory offers little guidance on the matter. By definition, global exports are always equal to imports. In a conventional Keynesian model, countries with trade deficits would gain some demand from a trade war, while countries with surpluses would lose some demand. However, the contribution of net exports to global demand would always be zero. Granted, there would be some efficiency losses, but in the standard Ricardian model of comparative advantage, they would not be that large. As Box 1 explains, the deadweight loss from a tariff can be computed as one-half times the change in the tariff rate multiplied by the percentage-point decline in imports that results from the tariff. Suppose, for example, that a trade war leads to a 10% across-the-board increase in U.S. tariffs, which causes U.S. imports to fall by 30%.2 Given that imports are 15% of U.S. GDP, the resulting deadweight loss would be 0.5*0.1*0.3*15=0.225% of GDP. That's obviously not a lot. The True Cost Of A Trade War Is Likely To Be High Our sense is that the true cost of a trade war would be much greater than these simple models suggest. There are at least six reasons for this: Most simple models assume that labor and capital are completely fungible and that the economy is always at full employment. In practice, it is doubtful that workers could easily move to companies that would benefit from tariff protection from those that would suffer from retaliatory measures. Workers have specialized skills. Likewise, a piece of machinery that is useful in one sector of the economy may be completely useless in another. Industries are often concentrated in particular regions. As such, a trade war could severely degrade the value of the existing stock of human and physical capital. This would result in lower potential GDP. It would also result in temporarily higher unemployment as workers, laid off from firms which have been adversely affected by tariffs, are forced to scramble for a new job elsewhere. Comparative advantage is not the only source of trade gains. Arguably more important are economies of scope and scale. A firm that has access to a global market can spread fixed costs over a larger quantity of output, thus lowering average costs (and ultimately prices). The existence of large global markets also allows companies to offer niche products that might not be worthwhile to develop for smaller markets. Modern trade is dominated by the exchange of intermediate goods within complex supply chains (Chart 4). This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. U.S. firms are particularly vulnerable to supply-chain disruptions because the Trump administration has dotardly chosen to levy tariffs mainly on intermediate and capital goods (Chart 5). This stands in contrast to China and the EU, which have raised tariffs mainly on final goods in a politically strategic manner (agricultural products in Trump-supporting rural areas and Harley Davidson bikes, which are manufactured in Paul Ryan's home district in Wisconsin). Chart 4Trade In Intermediate Goods Dominates Chart 5The U.S. Is Not Very Smart In ##br## Implementing A Protectionist Agenda Uncertainty over the magnitude and duration of a trade war could cause companies to postpone new investment spending. A vast economic literature pioneered by Avinash Dixit and Robert Pindyck has shown that firms tend to defer capital expenditure decisions when faced with rising uncertainty.3 Furthermore, as I discussed in an academic paper which was published early on in my career, business investment is typically higher when firms have access to larger markets.4 Higher tariffs could lead to an implicit tightening in fiscal policy. If the U.S. raises tariffs by an average of ten percentage points across all imports, a reasonable estimate is that this would imply a tightening in fiscal policy by around 1% of GDP - enough to wipe out the entire stimulus from Trump's tax cuts. Of course, the tariff revenue could be injected back into the economy through more tax cuts or increased spending. However, given the possibility that gridlock will increase in Washington if the Republicans lose the House of Representatives in November, it is far from obvious that this would happen. A trade war would lead to lower equity prices and higher credit spreads. This would translate into tighter financial conditions. Historically, changes in financial conditions have been highly correlated with changes in real GDP growth (Chart 6). Changes in financial conditions have, in turn, led the stock market. The S&P 500 index has risen at an annualized pace of 10% since 1970 when BCA's Financial Conditions Index (FCI) was above its 250-day moving average, while gaining only 1.5% when the FCI was below its 250-day average (Chart 7). Given today's elevated valuations across many asset markets, the risk is that a trade war triggers a sizable correction in asset prices. Chart 6Changes In Financial Conditions Have Been Highly Correlated With Changes In Real GDP Growth Chart 7The Link Between Financial Conditions ##br##And The Stock Market Protecting Your Equity Portfolio From A Trade War We think investors are understating the risks of a trade war. This, along with a host of other reasons, prompted us to downgrade global risk assets from overweight to neutral on June 20.5 As bad as a trade war would be for Main Street, it would be even worse for Wall Street. The mega- cap companies that comprise the S&P 500 have a lot more exposure to foreign markets and global supply chains than the broader U.S. economy. The "beta" of corporate profits to changes in GDP growth is also quite high (Chart 8). Chart 9 shows how U.S. equity sectors performed during days when the S&P 500 suffered notable losses due to heightened fears of protectionism. We identified seven separate days, including Wednesday's selloff, which was spurred by Trump's threat to impose tariffs on another $200 billion of Chinese imports. Chart 8Profits Are Much More Volatile Than GDP Chart 9This Is How Markets Trade When They Are Worrying About Trade Wars The chart shows that deep cyclical sectors such as industrials, materials, and energy fared badly during days of protectionist angst. Financials also underperformed, largely because such days saw a flattening of the yield curve. Tech, health care, and telecom performed broadly in line with the S&P 500. Consumer stocks outperformed the market, but still declined in absolute terms. Utilities and real estate were the only two sectors that saw absolute price gains. Considering that the sector composition of European and EM bourses tends to be more tilted towards cyclicals than the U.S., it is not surprising that the former have underperformed during days of increased protectionist worries. Bonds: Yields Likely To Rise, But A Trade War Is A Risk To That View In contrast to equities, a trade war would benefit Treasurys and other safe-haven government bonds. Admittedly, the imposition of tariffs would push up import prices. However, the effect on inflation would be temporary. Just as the Fed tends to disregard one-off increases in commodity prices, it will play down any transient boost to inflation stemming from a trade war. Instead, the Fed will focus on the growth impact, which is likely to be negative. To be clear, trade jitters are not the only thing affecting bond yields. Judging by numerous business surveys, the U.S. economy is starting to overheat (Chart 10). Last week's employment report does not alter this conclusion. While the unemployment rate rose by 0.2 percentage points, this was mainly because of a jump in the participation rate. Considering that the number of workers outside the labor force who want a job is near a record low, the ability of the economy to draw in additional workers is limited (Chart 11). Chart 10The U.S. Economy Is Overheating Chart 11A Small Pool Of People Want ##br##To Jump Into The Labor Market Historically, continuing unemployment claims have closely tracked the unemployment rate over time (Chart 12). The fact that continuing claims have dropped by 9% since the end of January, while the unemployment rate has dipped by only 0.1 percentage points, suggests that the unemployment rate will fall further over the coming months. On balance, we continue to maintain our bearish recommendation on Treasurys, but acknowledge that a trade war is a risk to that view. Trade Wars And Currencies Unlike safe-haven bonds, whose yields are likely to decline in proportion to the magnitude of the trade war, the impact on the dollar is more difficult to predict. On the one hand, a modest trade dispute is likely to be somewhat dollar bearish, inasmuch as it hurts U.S. growth and forces the Fed to slow the pace of rate hikes. Since most other major central banks are not in a position to cut rates, expected rate differentials between the U.S. and its trading partners would narrow. On the other hand, a severe trade war would probably be dollar bullish. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. still tend to attract capital inflows into the safe-haven Treasury market. The U.S. is a fairly closed economy, and hence would be relatively less affected by a breakdown in global trade. Commodities are also likely to suffer if trade flows decline (Chart 13). Lower commodity prices tend to be bullish for the greenback. Moreover, as we discussed in our latest Strategy Outlook, a tit-for-tat trade war with China could force the Chinese government to devalue the yuan. That would have a knock-on effect on other emerging market currencies. Chart 12Unemployment Can Fall Further Chart 13Commodities Are A Potential Victim Of Trade War Notably, the greenback has fared better recently than it did earlier this year during days when protectionist rhetoric intensified. On Wednesday, the broad trade-weighted dollar gained 0.3% while the DXY picked up 0.6%. This supports our view that the dollar will strengthen over the remainder of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 2 This assumes an elasticity of import demand of 3, which is broadly consistent with most academic estimates. 3 Avinash K. Dixit, and Robert S. Pindyck, "Investment Under Uncertainty," Princeton University Press, (1994). 4 Peter Berezin, "Border Effects Within A Dynamic Equilibrium Trade Model," The International Trade Journal, 14:3 (2000), 235-282. 5 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. BOX 1 The Deadweight Loss From A Trade War Box Chart 1Tariffs Increase Budget Revenues, But Lead To A Bigger Loss In Consumer Surplus In the simplest models of international trade, an increase in tariffs leads to higher prices, resulting in a loss of consumer surplus. This is depicted by the blue region (ABCE) in Box Chart 1. The government collects revenue from the tariff shown by the red-colored rectangle (ABDE). The difference between the loss in consumer surplus and the gain in revenue - often referred to as the "deadweight loss" from a tariff - is depicted by the green-colored triangle (BCD). Arithmetically, the area of the triangle can be calculated as: Deadweight loss = 0.5 x Tariff x (Pre-tariff level of imports - Post-tariff level of imports) If one divides both sides by GDP, the formula reduces to: Deadweight loss/GDP = 0.5 x Tariff x Percentage Point Change In Import Share of GDP Resulting From Tariff There are many things in the real world that are not captured by this equation. For example, if the country that imposes the tariff is sufficiently large, this could push down the international price of the goods that it imports. The country would then benefit from an improvement in its terms of trade. As Robert Torrens showed back in the 19th century, if a country has any degree of market power (i.e., it is not a complete price-taker on international markets), there will always be a level of tariffs that makes it better off. The caveat is that this "optimal tariff" only exists if other countries do not retaliate. If everyone retaliates against everyone else, everyone will be worse off from a trade war. Moreover, as discussed in the main text, there are many factors that this simple model does not capture which could result in significant economic damage from raising tariffs even when retaliation does not take place, especially in cases where the tariffs are imposed on intermediate and capital goods. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) Chart 12Total Return Bond Map (As Of July 6, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Table II-2Stress Test Of Top 5 Chinese Public Banks Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
The GAA DM Equity Country Allocation model is updated as of June 29, 2018. The model has reduced weights in Italy, the U.S., the Netherlands and France to beef up weights in Spain, Australia, Canada, Switzerland and Germany. After these adjustments, Australia is now upgraded to overweight from neutral and Italy is downgraded to neutral from overweight, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 34 bps in June, largely driven by the Level 2 model which outperformed its benchmark by 87 bps. The Level 1 model performed in line with its benchmark in June. Since going live, Level 2 and Level 1 have outperformed their respective benchmarks by 171 bps and 5bps, resulting in overall model outperformance of 47 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of June 30, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Following our Quarterly Update that was released yesterday, the model corroborates the defensive stance with an aggregate underweight of 5.8% in cyclical sectors. The switch to a defensive mode was driven by a weaker growth outlook. The upgraded sectors were consumer staples and health care. Additionally, the model has turned more negative on the two largest sectors - financials and technology. Resources-based sectors remain unattractive on the back of weaker growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.
Highlights Portfolio Strategy Five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Lift to neutral. This also raises the S&P health care sector exposure to neutral, as these two heavyweight health care sub-indexes command a 49% weighting in the sector. Recent Changes Act on the upgrade alert and lift the S&P pharma and S&P biotech indexes to neutral today for a profit of 14.5% and 13.9%, respectively since inception (we are also removing the S&P pharma index from our high-conviction underweight list). Lock in gains in the S&P health care sector of 5.3% since inception and upgrade exposure to a benchmark allocation today. Table 1 Feature Stocks continued to wrestle with escalating geopolitical threats last week, but remained resilient. While the global trade soft patch could morph into a steep contraction if protectionism proliferates, our working assumption is that the executive branch's bark will be worse than its bite. The SPX is in the midst of a recalibration to a cooling in EPS momentum in calendar 2019 as we have been highlighting in recent research, and were the U.S. dollar to continue its ascent in the back half of the year, the sell-side's calendar 2019 almost 10% growth estimate will sink like a stone. This remains our number one downside risk that we are closely monitoring, though it should be reasonably contained by mounting signs of a healthier corporate sector and an easing in financial stress (Chart 1). This week we are updating our corporate pricing power proxy that has reaccelerated. Importantly, the breadth of the surge has gone parabolic, which bodes well for its staying power (second panel, Chart 2). This firming corporate inflation backdrop suggests that businesses have been successful in passing on skyrocketing input costs down the supply chain, and thus implies that final demand remains robust. Chart 1Reset Chart 2Pricing Power Flexing Its Muscles On the flip side, rising labor costs have stabilized. Compensation growth remains contained, and according to our diffusion index, just over half of the 44 industries we track have to contend with rising wages. In addition, the Atlanta Fed Wage Growth Tracker switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses and it recently ticked down. In other words, pricing power is rising on a broad basis while wage inflation is moving laterally. Consequently, there are decent odds that upbeat forward operating margin expectations are attainable, further prolonging the near two year margin expansion phase (bottom panel, Chart 2). Delving deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 80% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is on a par with our late-April report. Chart 3Cyclicals Come Out On Top Outright deflating sectors increased by two to 12 since our last update. Encouragingly, only 7 industries are still experiencing a downtrend in selling price inflation, in line with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 3). Despite the ongoing global export jitters, escalating trade war fears and year-to-date gains in the greenback, the commodity complex's ability to increase prices is extraordinary. In contrast, airlines, soft drinks, telecom, autos and tech populate the bottom ranks of Table 2. In sum, accelerating business sector selling prices will continue to underpin top line growth in the back half of the year. Recent evidence of a slight letdown in wage inflation is welcome news for corporate sector profit margins and earnings. In fact, it will be critical for labor costs to remain tame or at least continue to trail pricing power gains, otherwise profit margins will be at risk of a squeeze. This week we are locking in gains and lifting a defensive sector to a benchmark allocation by acting on our recent upgrade alert on two of its key subcomponents. Upgrade Pharma & Biotech To Neutral... We are pulling the trigger on our recent upgrade alerts and are upgrading the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively since inception, and we are also removing the S&P pharma index from our high-conviction underweight list. As a reminder, we set the heavyweight S&P pharmaceuticals and S&P biotech indexes on upgrade alert, and thus the overall S&P health care sector, on May 22nd following the insight from our Special Report titled 'Portfolio Positioning For A Late Cycle Surge'. In more detail, health care stocks excel in both phases we examined - ISM peak-to-SPX peak and SPX peak-to-recession commencement (Tables 3, 4 & 5). This is largely due to the high-beta biotech sub-sector outperforming early with the more defensive pharma sub-group sustaining the outperformance following the SPX peak. Table 3Health Care Outperforms In The Late Cycle Table 4High Beta Stocks Outperform Early... Table 5...Defensive Stocks Beat Late Moreover, recent pricing power developments point to a softer than previously expected blow to drug pricing practices revealed in the President's recent speech. This is music to the ears of Big Pharma executives and can serve as a catalyst to unlock latent buying power in this traditionally considered defensive sector. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net positive for pharma and biotech top line growth at least from a cyclical perspective (Chart 4). The thesis we postulated last July was that the easy pricing power gains were behind the pharma and biotech industries and likely a secular decline in the ability of these groups to raise prices at a faster pace than overall inflation was in order (Chart 5). While this thesis remains intact from a structural perspective, in the next 9-12 months there is scope for some relief. Chart 4Overdone Cyclically... Chart 5...But Structural Issues Remain Beyond these two drivers, the trade-weighted U.S. dollar's year-to-date gains also signal that it no longer pays to be bearish this safe haven group. Chart 6 shows that relative pharma profits are positively correlated with the greenback as Big Pharma's domestically-derived earnings dwarf foreign sourced EPS. Keep in mind that the industry still dictates terms to the U.S. government, a key end-market. The opposite is true with regard to other governments around the world, especially in the key European markets, where the industry is a price taker. This partially explains the positive correlation with the currency. On the operating front, there are also signs of a bottom. Not only are pharmaceutical factories humming, but also our pharma productivity proxy (industrial production / employment) is gaining steam, underscoring that profits can surprise to the upside (second panel, Chart 7). Chart 6Appreciating Dollar Helps Chart 7Bullish Operating Metrics With regard to demand, pharma retail sales are expanding nicely and overall industry shipments are also rising at a healthy clip, at a time when inventories are whittled down (third and bottom panels, Chart 7). This represents a positive pharma pricing power backdrop in the coming quarters. In terms of investor and analyst sentiment, a near full capitulation has taken root. Relative share price momentum is steeply contracting close to 15%/annum, a rate that has previously coincided with cyclical troughs (second panel, Chart 4). Sell-side pessimism reigns supreme as pharma profits are slated to trail the broad market by a wide margin both for the next year and on a 3-5 year time frame. In fact, the latter just sunk to all-time lows (Chart 8). Analyst gloom is pervasive as relative top line growth expectations also call for a contraction in the coming twelve months. Valuations are as good as they get with the relative forward price-to-earnings ratio trading way below par and the historical mean (bottom panel, Chart 8). Finally, the S&P pharma and S&P biotech indexes are more alike than different, as biotech stocks have long had blockbuster billion dollar selling drugs and therefore have substantial earnings (unlike 78% of the NASDAQ biotech index that do not even have forward earnings) and are really disguised pharma outfits hiding under the biotech label. The biotech index also offers a near 2% dividend yield, on par with the SPX, but still trailing the S&P pharma index roughly by 70bps (Chart 9). As such, there is an inverse correlation of both indexes with interest rates. Not only are higher interest rates punitive to growth stocks, but also fierce competitors to fixed income proxies. The implication is that if the broad equity market reset continues for a while longer and the 10-year Treasury yield continues to fall, relative share prices will likely come out of their recent funk (Chart 10). Chart 8Full Capitulation Chart 9Close Siblings... Chart 10...That Despise Higher Rates Adding it up, five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Bottom Line: Lock in profits of 14.5% and 13.9% in the S&P pharma and S&P biotech indexes respectively since inception and lift to a benchmark allocation. Also remove the S&P pharma group from the high-conviction underweight list. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. ...Which Lifts Health Care To A Benchmark Allocation The S&P pharma and biotech indexes command roughly a 50% weighting in the S&P health care sector. As a result, their profit fortunes are closely tied and relative share prices tend to move in lockstep (Chart 11). Today's upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Relative share prices have been in correction mode for the better part of the past year and may now have found support near their upward sloping long-term trend line (top panel, Chart 12). Importantly, our S&P health care EPS growth model is making an effort to trough (bottom panel, Chart 12), and if the Trump Administration does not clamp down on pharma pricing power as initially feared and recently hinted at, then overall health care sector profits will likely overwhelm. Keep in mind that the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. Similar to the S&P pharma index, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive (third panel, Chart 13). Chart 11Joined At The Hip Chart 12EPS Model Says Trough Is Near Chart 13Underappreciated And Unloved We would not hesitate to lift exposure further to overweight were the Trump Administration to put forth a bill with minimal damage inflicted upon drug prices, were the green back to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We are acting on our May 22nd upgrade alert and lifting the S&P health care sector to neutral, crystalizing relative profits of 5.3% since the July 31st, 2017 inception. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Recommended Allocation Risks to equities and credit are now evenly balanced. We downgrade both to neutral. We are worried that desynchronized growth will further push up the dollar, damaging emerging markets, especially since U.S. inflation will remove the Fed "put". The trade war is nowhere near over, and China shows signs of slowing growth. To de-risk, we raise U.S. equities to overweight, cut the euro zone to neutral, and increase our underweight in EM. We move overweight in cash, rather than fixed income because, with inflation still rising, we see U.S. 10-year rates at 3.3% by year-end. We turn more cautious on equity sectors (reducing the pro-cyclicality of our recommendations by raising consumer staples and cutting materials) and suggest less pro-risk tilts for alternative assets, shifting to hedge funds and away from private equity. Overview Lowering Risk Assets To Neutral Since last December we have been advising risk-averse clients, who prioritize capital preservation, to turn cautious, but suggested that professional fund managers who need to maximize quarterly performance stay invested in risk assets. With U.S. equities returning 3% in the first half of the year and junk bonds 0% (versus -1% for U.S. Treasury bonds), that was probably a correct assessment. Now, however, our analysis indicates that the risk/reward trade-off has deteriorated. Although we still do not expect a global recession until 2020, risks to the global equity bull market have increased. The return outlook is asymmetrical: a last-year bull market "melt-up" could give 15-20% upside, but in bear markets over the past 50 years global equities have seen peak-to-trough declines of 25-60% (Table 1). We think it better to turn cautious too early. A key to successful asset allocation is missing the big drawdowns - but getting the timing of these right is a near impossibility. Table 1How Much Stocks Fall In Bear Markets Chart 1Growth Is Becoming More Desynchronized What are the risks we are talking about? Global growth is slowing and becoming less synchronized (Chart 1). Fiscal stimulus and a high level of confidence among businesses are keeping U.S. growth strong, with GDP set to grow by close to 3% this year and S&P 500 earnings by 20%. But the euro zone and Japan have weakened, and these growing divergences are likely to push the dollar up further, which will cause more trouble in emerging markets. EM central banks are reacting either by raising rates to defend their currencies (which will hurt growth) or by staying on hold (which risks significant inflation). With the U.S. on the verge of overheating, the Fed will need to prioritize the fight against inflation. Lead indicators of core inflation suggest it is likely to continue to rise (Chart 2). The FOMC's key projections seem incompatible with each other: it sees GDP growth at 2.7% this year (well above trend), but unemployment barely falling further, bottoming at 3.6% by end-2018 (from 3.8% now) and core PCE inflation peaking at 2.1% (now: 2.0%). A further rise in inflation means that the Fed "put option" will expire: even if there were a global risk-off event, the Fed might not be able to put tightening on hold. It will take only one or two more hikes for Fed policy to be restrictive - something we have previously flagged as a key warning signal (Chart 3). Chart 2U.S. Inflation Could Pick Up Further Chart 3Fed Policy Is Close To Being Restrictive There is no end in sight for the trade war. President Trump is unlikely to back down on imposing further tariffs on China, since the tough stance is proving popular with his support base. On the other hand, President Xi Jinping would lose face by giving in to U.S. demands. BCA's geopolitical strategists warn that we are not at peak pessimism, and do not rule out even a military dimension.1 China is unlikely to roll out stimulus, as it did in 2015. With the authorities focused on structural reform, for example debt deleveraging, the pain threshold for stimulus is higher than in the past. Recent moves such as reductions in banks' reserve requirement have had little impact on effective interest rates (Chart 4). More likely, China might engineer a weakening of the RMB, as it did in 2015. There are signs that it is already doing so (Chart 5). This would exacerbate political tensions. Chart 4China Has Not Eased Monetary Conditions... Chart 5...But It Might Be Depreciating The RMB As we explain in detail in the pages that follow, with risk now two-way, we cut our weighting in global equities to neutral. We are not going underweight since global economic growth remains above trend, and corporate earnings will continue to grow robustly (though no faster than analysts are already forecasting). We see upside risk if the Fed were to allow an overshoot of inflation amid strong growth. If the concerns highlighted above cause a 15% correction in equity markets - triggering the Fed to go on hold - we would be inclined to move back overweight (having in mind a scenario like 1987 or 1998, where a sell-off led to a last-year bull-market rally). More likely, however, we will move underweight at the end of the year, when recession signals, such as an inverted yield curve, appear. We have shifted our detailed recommendations to line up with this de-risking. We move overweight U.S. equities (which are lower beta, and where unhedged returns should benefit from a stronger dollar). We keep our overweight on Japan, since the Bank of Japan remains the last major central bank in fully accommodative mode. We increase our underweight in EM equities. Among sectors, we reduce pro-cyclicality by cutting materials to underweight and raising consumer staples to overweight. We remain underweight fixed income, since inflationary pressures point to the 10-year U.S. Treasury bond yield moving up to 3.3% before the end of this cycle. We remain short duration and continue to prefer inflation-linked securities over nominal bonds. Within fixed income, we cut corporate credit to neutral, in line with our de-risking. Finally, we recommend that investors move into cash rather than bonds, though we understand that, especially for European investors, this may mean accepting a small negative return.2 Still puzzled how markets may pan out over the next 12 months? Then join BCA's annual Conference in Toronto this September, where I will be chairing a panel on asset allocation, featuring two experienced Chief Investment Officers, Erin Browne of UBS Asset Management, and Norman Villamin of Union Bancaire Privée. Garry Evans, Senior Vice President garry@bcaresearch.com What Our Clients Are Asking How To Overweight Cash? Chart 6Sometimes Cas Is The Only Answer BCA's call to start to derisk portfolios includes a new overweight in cash. This is logical since, historically, cash often outperformed both equities and bonds early in a downturn, when growth was starting to falter (bad for equities) but inflation was still rising (bad for bonds) - though this last happened in 1994 (Chart 6, panel 1). Currently, a move to cash is easy for U.S. investors, who can invest in three-month Treasury bills yielding 1.9%, or USD money market funds, some of which offer just over 2%. But it is much harder for investors in the euro area, where three-month German government bills yield -0.55%. Also, in Japan cash yields -0.17% and in Switzerland -0.73%. Some European investors will be tempted to go into U.S. cash. Given our view of dollar appreciation over the next six months, this should pay off. But it clearly is risky, should we be wrong and the dollar decline. As theory predicts, the cost of hedging the U.S. dollar exposure wipes out any advantage (since three-month euro-dollar forwards are 2.7% lower on an annualized basis than EURUSD spot). Some investors will have to put up with a small negative return in nominal terms in order to (largely) protect their capital. More imaginative European fund managers might be able to come up with schemes to get cash-like returns but with a positive return. For example, Danish mortgage bonds yield 1.8% (in Danish krone, which is largely pegged to the euro) with little risk. U.S. mortgage-backed securities offer yields well over 3%, which should give a positive return after hedging costs (and relatively low risk, given the robust state of the U.S. housing market) - panel 3. Carefully-selected global macro hedge funds can give attractive Libor-plus returns.3 We still see attractiveness of catastrophe bonds,4 which have a high yield and no correlation to the economic cycle. How Seriously Should We Take The Risk Of A Trade War? Is this a full-blown trade war? The answer is not yet. However, the risk is rising that the current spat will turn into one. President Trump has escalated tensions further by indicating that a 10% tariff would be placed on $200 billion of Chinese imports, in addition to the 25% tariff on $50 billion of imports announced in March and to be implemented on July 6. Trump's incentive to escalate the conflict is that a tough trade policy plays well with his support base (Chart 7). Ever since the trade issue hit the headlines early this year, his approval ratings have been on the rise. This means that he is unlikely to back down at least until the mid-term elections in November. Xi Jinping is also unlikely, for his own political reasons, to give in to U.S. demands. But China's retaliation will most likely come through non-tariff actions, since its imports from the U.S. total only about $130 billion (compared to $500 billion of Chinese exports to the U.S.). It could look to restrict imports, for example via quotas, or cause extra bottlenecks for U.S. businesses operating in China. Additionally, it could threaten to sell some of its holdings of U.S. Treasuries, or devalue the RMB. As Chart 8 shows, the RMB has already weakened against the dollar this year (though this was mainly due to the dollar's overall strength). There are suggestions that China might adjust the currency basket that it targets for the RMB, for example by adding more Asian currencies, to allow further depreciation against the dollar. Chart 7 Chart 8Sharp Rise In RMB This Year It is hard, then, to see a smooth outcome to this standoff. A further escalation could even have a military dimension, with the U.S. having recently opened a new "embassy" in Taiwan, and sailing navy vessels close to Chinese "islands" in the South China Sea. It is also a complication that President Trump has recently raised tensions with other G7 trading partners, rather than engaging their help in combatting China's perceived unfair trading practices. Is It Time To Buy Chinese A-Shares? In Q2 2018, MSCI China A-shares lost 19% in absolute terms, compared to a 3.5% gain for MSCI U.S. Some investors attribute this performance divergence to trade tension between the U.S. and China, and take the view that the Chinese government may step in to stimulate the economy and support the equity market, similar to what happened in 2015. We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. Given elevated debt levels and excess capacity in some parts of the economy and worries about pollution, however, the bar for a fresh round of stimulus is a lot higher than in the past. With the incremental inclusion of MSCI on-shore A-Shares into the MSCI China investible universe, A-shares are gaining more attention from international investors. However, the A-Share Index is very different from the MSCI China Index. First, the sector compositions are very different, as shown in Chart 9. The MSCI China index is not only dominated by the tech sector (40%), it's also very concentrated, with the top 10 names accounting for 56% of the index, while the top 10 names in the A-shares account for only about 20%. Second, even in the same sectors, the performance of the two indexes has diverged as shown in Chart 10. We see the reason for these divergences being that domestic investors are more concerned about growth in China than foreign investors are. Instead of buying A-Shares, investors should be more cautious on the MSCI China Index, for which we have a neutral view within MSCI EM universe. Chart 9 Chart 10ONE CHINA, TWO DIFFERENT EQUITY INDEXES What Are The Characteristics Of The Private Debt Market? Chart 11Private Debt Market Private debt (Chart 11) raised a record $115 billion through 158 funds in 2017, pushing aggregate AUM from $244 billion in 2007 to $664 billion in 2017. This explosive growth was driven by bank consolidation in the U.S., increased financial sector regulation, and the global search for yield. Private debt has historically enjoyed a higher yield and return, along with fewer defaults, than traditional public-market corporate bonds. Below are some of the key points from our recent Special Report:5 Private debt has returned an average net IRR of 13% from 1989 to 2015. This compares to an annualized total return of 7% and 7.2% for equities and corporate bonds respectively. Investors can diversify their sources of risk and return by giving access to more esoteric exposures such as illiquidity and manager skill. The core risk exposure in private debt comes from idiosyncratic firm-specific sources, which is not the case with publicly traded corporate credit. Investors can gain more tailored exposure to different industries and customized duration horizons. Additionally, private debt was the only group in the private space that did not experience a contraction in AUM during the financial crisis. Direct lending and mezzanine debt are capital preservation strategies that offer more stable returns while minimizing downside. Distressed debt and venture debt are more return-maximizing strategies that offer larger gains, but with a higher probability of losses. In the late stages of an economic cycle, investors should deploy capital defensively through first-lien and other senior secured debt positions. In contrast, a recession would create opportunities for distressed strategies and within deeper parts of the capital structure. Global Economy Overview: Growing divergences are emerging in global growth, with the U.S. producing strong data, but a cyclical slowdown in the euro area and Japan, and the risk of significantly slower growth in China and other emerging markets. This means that monetary policy divergences are also likely to increase, exacerbating the rise in the U.S. dollar and putting further pressure on emerging markets. Eventually, however, tighter financial conditions could start to dampen growth in the U.S. too. U.S.: Data has been very strong for the past few months, with the Fed's two NowCasts pointing to 2.9% and 4.5% QoQ annualized GDP growth in Q2. Small businesses are confident (with the NFIB survey at a near record high), which suggests that the capex recovery is likely to continue. With unemployment at the lowest level since 1969, wages should pick up soon, boosting consumption. But it is possible the data might now start to weaken. The Surprise Index (Chart 12, panel 1) has turned down. And a combination of trade war and a stronger dollar (up 8% in trade-weighted terms since April) might start to dent business and consumer confidence. Chart 12U.S. Growth Remains Strong... Chart 13...While Europe, Japan And EMs Start To Slow Euro Area: Euro area data, by contrast to the U.S., have turned down since the start of the year, with both the PMI and IFO slipping significantly (Chart 13, panel 1). This is most likely because the 6% appreciation of the euro last year has affected export growth, which has slowed to 3.1% YoY, from 8.3% at the start of the year. However, the PMI remains strong (around the same level as the U.S.) and, with a weaker euro since April, growth might pick up late in the year, as long as problems with trade and Italy do not deteriorate. Japan: Japan's growth has also slipped noticeably in recent months (Chart 13, panel 2), perhaps also because of currency strength, though question-marks over Prime Minister Abe's longevity and the slowdown in China may also be having an effect. The rise in inflation towards the Bank of Japan's 2% target has also faltered, with core CPI in April back to 0.3% YoY, though wages have seen a modest pickup to 1.2%. Emerging Markets: China is now showing clear signs of slowing, as the tightened monetary conditions and slower credit growth of the past 12 months have an effect. Fixed-asset investment, retail sales and industrial production all surprised to the downside in May. The authorities have responded to this (and to threat of trade disruptions) by slightly easing monetary policy, though this has not yet fed through to market rates, which have risen as a result of rising defaults. Elsewhere in EM, many central banks have responded to sharp declines in their currencies by raising rates, which is likely to dampen growth. Those, such as Brazil, which refrained from defensive rate hikes, are likely to see an acceleration in inflation Interest rates: The Fed has signaled that it plans to continue to hike once a quarter at least for the next 12 months. It may eventually have to accelerate that pace if core PCE inflation moves decisively above 2%. The ECB, by contrast, announced a "dovish tightening" last month, when it signaled the end of asset purchases in December, but no rate hike "through the summer" of next year. It can do this because euro zone core inflation remains around 1%, with fewer underlying inflationary pressures than in the U.S. The Bank of Japan is set to remain the last major central bank with accommodative policy, since it is unlikely to alter its yield-curve control any time soon. Global Equities Chart 14Neutral Global Equities A Bird In The Hand Is Worth Two In The Bush: After the initial strong recovery from the low in March 2009, global equity earnings have risen by only 20% from Q3 2011, and that rise mostly came after February 2016. In the same period, global equity prices, however, have gained over 80%, largely due to multiple expansion (Chart 14), supported by accommodative monetary and stimulative fiscal policies. Year-to-date, our pro-cyclical equity positioning has played out well with developed markets (DM) outperforming emerging markets (EM) by 8.8%, and cyclical equities outperforming defensives by 2.9%. As the year progresses, however, we are becoming more and more concerned about future prospects given the stage of the cycle, stretched valuations and the elevated profit margin.6 The three macro "policy puts", namely the Fed Put, the China Put and the Draghi Put, are all in jeopardy of disappearing or, at the very least, of weakening, in addition to the risk of rising protectionism. BCA's House View has downgraded global risk assets to neutral.7 Reflecting this change, within global equities we recommend investors to take a more defensive stance by reducing portfolio risk. We remain overweight DM and underweight EM; We upgrade U.S. equities to overweight at the expense of the euro area (see next page); Sector-wise, we suggest to take profits in the pro-cyclical tilts and become more defensive (see page 14). Please see page 21 for the complete portfolio allocation details. U.S. Vs. The Euro Area: Trading Places Chart 15Favor U.S. Vs. Euro Area In line with the BCA House View to reduce exposure in global risk assets, we are downgrading the euro area to neutral in order to fund an upgrade of the U.S. to overweight from neutral, for the following reasons: First, GAA's recommended equity portfolio has always been expressed in USD terms on an unhedged basis. Historically, the relative total return performance of euro area equities vs. the U.S. has been highly correlated with the euro/USD exchange rate. With BCA's House View calling for further strength of the USD versus the euro, we expect euro area total return in USD terms to underperform the U.S. (Chart 15, panel 1). Second, the euro area economy has been weakening vs. the U.S. as seen by the relative performance of PMIs in the two regions; this bodes ill for the euro area's relative profitability (Chart 15, Panel 2). Third, because euro area equities have a much higher beta to global equities than U.S. equities do, shifting towards the U.S. reduces the overall portfolio beta (Chart 15, Panel 3). Last, even though euro area equities are cheaper than the U.S. in absolute term, they have always traded at a discount to the U.S. On a relative basis, this discount is currently fair compared to the historical average. Sector Allocation: Become More Defensive Chart 16Sectors: Turn Defensive Year to date, our pro-cyclical sector positioning has worked very well, especially the underweights in telecoms, consumer staples and utilities, and the overweight of energy. The overweight in healthcare also has worked well, but the overweights in financials and industrials, as well as the underweight of consumer discretionary, have not panned out. Global economic growth has peaked, albeit at a high level. This does not bode well for the profitability of the economically sensitive sectors (industrials, consumer discretionary and materials) relative to the defensive sectors (healthcare, consumer staples and telecoms), as shown in Chart 16, top two panels. In addition, slowing Chinese growth will weigh on the materials sector, and rising tension in global trade will pressure the industrials sector. As such, we are upgrading consumer staples to overweight (from underweight) and telecoms to neutral, and downgrading materials to underweight (from neutral). Oil has gained 16% so far this year, driving energy equities to outperform the global benchmark by 6.2%. Going forward, however, the oil outlook is less certain as OPEC and Russia work to ease production controls, and demand is cloudy. This prompts us to close the overweight in the energy sector to stay on the sideline for now (Chart 16, bottom panel). We also suggest investors to reduce exposure in financials to a benchmark weighting due to our concerns on Europe and also the flattening of yield curves. After all these changes, we are now overweight healthcare and consumer staples while underweight consumer discretionary, utilities and materials. All other sectors are in line with benchmark weightings. Government Bonds Maintain Slight Underweight On Duration. BCA's house view has downgraded global risk assets to neutral and raised cash to overweight, while maintaining an underweight in fixed income.8 This prompts us to downgrade credit to neutral vs. government bonds (see next page). However, we still see rates rising over the next 9-12 months and so our short duration recommendation for the government bonds is unchanged. The U.S. Fed is on track to deliver a 25bps rate hike each quarter given robust business confidence and tight labor markets, and the ECB has announced it will stop new bond buying in its Asset Purchase Program after December this year. As such, bond yields are likely to move higher in both the U.S. and the euro area given the close relationship between 10-year term premium and net issuance (Chart 17). Chart 17Yields Will Rise Further Chart 18Favor Inflation-Linked Bonds Favor Linkers Vs. Nominal Bonds. The latest NFIB survey shows that wage pressure is on the rise, with reports of compensation increases hitting a record high (Chart 18, top panel). BCA's U.S. Bond Strategy still believes that the U.S. TIPS breakeven will rise to 2.4-2.5% around the time that U.S. core PCE inflation exceeds the Fed's 2% target rate (the Fed forecasts 2.1% by end-2018). Compared to the current breakeven level of 2.1%, this means 10-year TIPS has upside of 30-40bps, an important source of return in the low-return fixed income space (Chart 18, panel 2). Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds (Chart 18, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 19Spreads Not Attractive We have favored both investment-grade and high-yield corporates (Chart 19) over government bonds for over two years. But, while monetary and credit conditions remain favorable, we think rising uncertainty and weakening corporate balance sheets in the coming quarters warrant a more cautious stance. We are moving to neutral on corporate credit. In Q1, outstanding U.S. corporate debt grew at an annualized rate of 4.4%, while pre-tax profits (on a national accounts basis) contracted by 5.7%, raising gross leverage from 6.9x to 7.1x. The benign default rates and tight credit spreads associated with robust economic growth are at risk now that leverage growth is soon poised to overtake cash flow growth, challenging companies' debt service capability. Finally, if labor costs accelerate, leverage will continue to rise in 2H18. Since February, our financial conditions index has tightened considerably driven by a combination of falling equity prices and a stronger dollar. As monetary policy shifts to an outright restrictive stance once inflation reaches the Fed's target later in 2018, corporates will suffer. The risk-adjusted returns to high yield (Chart 20) are no longer attractive relative to government bonds. Chart 20Junk Only Attractive If Defaults Stay Low Chart 21Rising Leverage Finally, valuations are expensive. Investment grade spreads have widened by 50bps from the start of the year, but junk spreads are still close to their post-crisis lows. As we are late in the credit cycle, we do not expect further contraction in spreads. For now monetary and credit quality indicators remain stable, but we are booking profits and moving both investment-grade and high-yield corporates to neutral. In the second half of the year, as corporate leverage (Chart 21) starts to deteriorate and monetary policy gets more restrictive, we will look to further review our allocations. Commodities Chart 22Strong Demand But Uncertain Supply In Oil Energy (Overweight): Underlying demand/supply fundamentals (Chart 22, panel 2) will continue to drive prices, as the correlation with the U.S. dollar breaks down. We expect the key OPEC countries to increase production by 800k b/d and over 210k b/d in 2H18 and 1H19 respectively. This will be offset by losses in the rest of OPEC of 530k b/d and 640k b/d in 2H18 and 1H19 respectively. Venezuelan production has dropped from a peak of 2.1m b/d to 1.4m b/d, and we expect it to reach 1.2m b/d by year end and 1.0m b/d by the end of 2019. Additionally, we expect Iranian exports to fall by 200k b/d to the end of 2018, and by another 300k b/d by the end of 1H19 as a result of sanctions. Demand seems to be holding up for now, but is conditional on developments in global trade. BCA's energy team forecasts Brent crude to average $70 in 2H18 and $77 in 2019. Industrial Metals (Neutral): China remains the largest consumer of metals, and so price action will react to underlying economic growth there and to the dynamics of its local metals markets. Additionally, a strengthening dollar will add downward pressure to prices and increase volatility. We expect a physical surplus in copper markets to emerge by year end, given slower demand growth and supply concerns due to restrictions on China's imports of scrap copper. Precious Metals (Neutral): Rising global uncertainties and geopolitical tensions driven by trade wars and divergent monetary policy will continue to keep market volatility high. During periods of equity market downturns, gold will continue to be an attractive hedge. Additionally, as inflationary pressures continue to rise, investors will continue to look for inflation protection in gold. However, rising interest rates and a strengthening dollar could limit price upside. We recommend gold as a safe-haven asset against unexpected volatility and inflation surprises. Currencies Chart 23Dollar Appreciation To Continue King Dollar U.S. Dollar: Following the recent strong economic data out of the U.S., the Fed is likely to maintain its moderately hawkish stance and follow its current dot plan of gradual rate hikes over the course of this year and next. For now the Fed is unlikely to accelerate the pace of hikes: it hinted that it could allow inflation to overshoot its target of 2% on core PCE. We expect the U.S. dollar to appreciate further over the coming months (Chart 23, panel 1). Euro: Disappointments in European economic data, in addition to political uncertainties in Italy, have led to a correction in the EUR/USD (Chart 23, panel 2). The ECB's indication that it will not raise rates through the summer of 2019 added further downward pressure on the currency. In addition, rising tension related to trade war and its impact on European growth is likely to dampen the euro's performance further. We look for EUR/USD to weaken to at least 1.12. JPY: The outlook for the yen is more mixed than for the euro. Japanese data over the past couple of months have been anemic, and interest rate differentials with the U.S. point to a weakening yen (Chart 23, panel 3). Moreover, the BoJ is still concerned with achieving its inflation target and so remains the last major central bank in full accommodative mode. However, escalating global tension is likely to be a positive factor for the JPY as a safe haven currency. It also looks far cheaper relative to PPP than does the euro. We see the yen trading fairly flat to the USD, but appreciating against the euro. EM Currencies: Tighter U.S. financial conditions, rising bond yields, and a strengthening dollar are all disastrous for EM currencies (Chart 23, panel 4). Additionally, the ongoing growth slowdown in China, and in EM as a whole, will add further downside pressures on most EM currencies. Alternatives Chart 24Turn Defensive On Alts Allocations to alternatives continue to rise as investors look for new avenues to preserve capital and generate attractive returns. We are turning more cautious on risk assets across all asset classes on the back of a possible growth slowdown and restrictive monetary policy. With intra-correlations between alternative assets reaching new lows (Chart 24), investors need to be especially careful picking the right category of alt investments. Return Enhancers: We have favored private equity over hedge funds since 1Q16, and this has generated an excess return of 20%. But, given our decision to scale back on risk assets on the back of a possible growth slowdown, we are turning cautious on private equity. Higher private-market multiples, stiff competition for buyouts from large corporates, and an uncertain macro outlook will make deal flow difficult. On the other hand, as volatility makes a comeback and markets move sideways, discretionary and systematic macro funds should fare better. We recommend investors pair back on their private equity allocations and increase hedge funds as we prepare for the next recession. Inflation Hedges: We have favored direct real estate over commodity futures since 1Q16; this position has generated a small loss of 1.4%. Total global commercial real-estate (CRE) loans outstanding have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. CRE prices peaked in late 2016, and are now flat-lining, partly due to the downturn of shopping malls and traditional retail. On the other hand, commodity futures have had a good run on the back of rising energy prices. We recommend investors reduce their real estate allocations, and put on modest positions in commodity futures as an inflation hedge. Volatility Dampeners: We have favored farmland and timberland over structured products since 1Q16, and this has generated an excess return of 6%. As noted in our Special Report,9 of the two, timberland assets tend to have a stronger correlation with growth, whereas farmland demand is relatively inelastic during times of a slowdown. Additionally, farmland returns tend to have lower volatility compared to timberland. Structured products will continue to suffer with rising rates. We recommend investors allocate more to farmland over timberland, and stay underweight structured products. Risks To Our View Chart 25What If China's Imports Weaken Sharply Our neutral view on risk assets implies that we see the upside and downside risks as evenly balanced. Could the macro environment turn out to be worse than we envisage? Clearly, there would be more downside for equities if the risks we highlighted in the Overview (slowing growth, U.S. inflation, trade war, Chinese policy) all come through. China and emerging markets are the key. China's import growth has been trending down for 12 months; could it turn significantly negative, as it did in 2015 (Chart 25)? Emerging markets look sensitive to further rises in U.S. interest rates and the dollar. The most vulnerable currencies have already fallen by up to 20% since the start of the year, but could fall further (Chart 26). We would not over-emphasize these risks, however. If growth were to slow drastically, China would roll out stimulus. Emerging markets are more resilient than they were in the 1990s, thanks to currencies that mostly are floating and generally healthier current account positions (though, note, their foreign-currency debt is bigger). Chart 26EM Currencies Could Fall Further Chart 27Is This An Excuse For The Fed To Be Dovish? On the positive side, the biggest upside risk comes from the Fed slowing the pace of rate hikes even though growth is robust. This might be because U.S. inflation remains subdued (perhaps for structural reasons) - or because the Fed allows an overshoot of inflation, either under political pressure, or because of arguments that its inflation target is "symmetrical" and that it has missed it on the downside ever since the target was introduced in 2012 (Chart 27). This would be likely to weaken the dollar, giving emerging markets a reprieve. It might lead to a 1999-like stock market rally, perhaps led again by tech - specifically, internet - stocks. 1 Please see What Our Clients Are Asking: How Seriously Should We Take The Risk Of A Trade War, on page 7 of this Quarterly for more analysis of this subject. 2 Please see What Our Clients Are Asking: How To Overweight Cash, on page 6 of this Quarterly for some suggestions on how to minimize this. 3 Please see Global Asset Allocation Special Report, "Hedge Funds: Still Worth Investing In?", dated June 16, 2017, available at gaa.bcaresearch.com 4 Please see Global Asset Allocation Special Report, "A Primer On Catastrophe Bonds", dated December 12, 2017, available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Private Debt: An Investment Primer", dated June 6, 2018, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation - Quarterly Portfolio Outlook, dated April 3, 2018, available at gaa.bcaresearch.com 7 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 8 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 9 Please see Global Asset Allocation - Special Report "U.S. Farmland & Timberland: An Investment Primer", dated October 24, 2017, available at gaa.bcaresearch.com GAA Asset Allocation
Highlights May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 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 U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.
Highlights Growing trade tensions are exacerbating risks created by a decline in global liquidity. A weaker CNY will only increase pressures on the dollar. China is in fact likely to try to push the CNY lower, as it is a useful tool to reflate the economy. USD/CNY at 7.1 is necessary to stabilize Chinese monetary conditions. However, at such a level, the yuan will flame fears that protectionist rhetoric in the U.S. will rise further. This catch-22 situation favors more weakness in the EUR, the GBP, the AUD and the CAD. It also suggests the yen could rebound a bit further. EUR/JPY still possesses ample downside. Feature Financial markets have experienced another bout of volatility. This spike in volatility has been very kind to the U.S. dollar, especially against EM and commodity currencies. Behind this market tumult lies yet another heating up in protectionist rhetoric, with U.S. President Donald Trump and China lobbing missiles at one another in the form of tariffs, both actual and threatened. The reaction of the dollar and EM assets has been especially violent, as the rising risk of a trade war is not happening in a vacuum: it is happening in an environment where global liquidity conditions have begun to tighten. For markets to improve, either the liquidity backdrop will have to become stronger, or the risks associated around trade will have to recede. At this point, we are reluctant to call the end of the current market tumult. Global liquidity has yet to improve, heated words on trade have yet to calm down, and most importantly, a key piece of the puzzle has yet to stabilize: the Chinese yuan. Because we see a high risk of more depreciation in the CNY, we continue to expect more downside for the euro, and even more downside for commodity and EM currencies. Liquidity Is Drying Up Why do markets sometimes lightly vacillate in front of geopolitical shocks, but on other occasions respond violently? The liquidity backdrop plays a big role. If liquidity is plentiful and growing, investors are more likely to judge the impact of political risks as passing, finding easy answers as to why a risk can be ignored, rightfully or wrongly. This time, investors are very worried about trade. It is true that if a trade war between the U.S. and China were to emerge, it would be devastating for global trade, growth, and profits. But in our view, investors have decided to pay more attention to this risk this time around because global liquidity is getting tighter, pointing to slower global growth. Under this set of circumstances, a trade war is just yet another risk that the market cannot abide. In our view, the following four indicators have been providing the key signals that global liquidity conditions are hurting global growth and making markets highly sensitive to any shocks: The yield curve: Both the U.S. and global yield curves have flattened considerably this year, despite 10-year Treasury yields being more than 40bps higher than at the end of 2017 (Chart I-1). Excess liquidity: Our preferred measure of global excess liquidity is contracting. The growth rate of the combined broad money aggregates in the U.S., the euro area and Japan has now fallen below the growth rate of loans. This means that the domestic economies of these three giants have been using all the money created by their banking systems, leaving little funds available for EM economies that in aggregate still run current account deficits and have accumulated large piles of foreign currency debt. Historically, this is a leading indicator of global growth (Chart I-2). Chart I-1Global Yield Curves Point To Declining Liquidity Chart I-2Excess Money Is Contracting Gold prices: Gold is extremely sensitive to global liquidity conditions, and gold prices seem to be breaking down, even as nominal and real bond yields are weakening (Chart I-3). A breakdown in gold preceded the EM selloff in the summer of 2015 and the ensuing economic slowdown. EM carry trades: EM carry trades financed in yen have been a very reliable leading indicator of the global industrial cycle, and they currently look very ill (Chart I-4). They suggest that money is exiting EM economies at a quick pace. Not only is this precipitating a sharp correction in EM assets, it is causing monetary aggregates in these countries to deteriorate. This is a potent headwind to their growth and to global trade. Chart I-3Gold Points To More Weaknesses ##br##In EM Assets Chart I-4EM Carry Trades Confirm The ##br##Decline In Global Liquidity In this context, we worry that one variable has further to adjust. Not only could this variable exact a deflationary influence on global markets, it will further fan the threats of trade wars. This is the CNY exchange rate. Bottom Line: Markets have been rattled by the rise in protectionist rhetoric in the U.S., which is raising the specter of a trade war with China and, to a smaller extent, with the EU. The market is especially vulnerable to this risk because global liquidity has already deteriorated, pointing to a further deceleration in global growth. In this context, if the CNY were to fall further, this could prompt a final wave of selling that will help the USD execute one more leap higher. The CNY Is Still At Risk In recent years, the USD/CNY exchange rate has behaved as a function of the trend in the DXY dollar index. This makes sense; the People's Bank of China, in conjunction with China's State Administration of Foreign Exchange (SAFE), targets the yuan against a basket of currencies. If the U.S. dollar is generally strong, the PBoC and SAFE need to let USD/CNY appreciate so that the yuan doesn't rise too much against other currencies in the reference basket. However, as Jonathan LaBerge has pinpointed in BCA's China Investment Strategy service, since President Trump has been threatening China with further tariffs, the CNY has been much weaker than implied by the DXY itself (Chart I-5).1 We believe that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy, as the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that will need to be softened if it indeed materializes. Second, letting the yuan depreciate is also a message to the U.S.: China can weaponize its currency if it has to. At this point we genuinely worry that China is not done with weakening the CNY, and a USD/CNY rate of 7.1 or higher is needed to boost monetary conditions, especially if our DXY target of 98 gets hit. The probability of this price action materializing is growing. First, in line with Beijing's efforts to engage the Chinese economy into a deleveraging exercise, Chinese monetary conditions have already been significantly tightened. As a result, monetary aggregates have significantly slowed, from narrow ones to broader ones. In fact, BCA's estimate of M3 is languishing at all times lows. It is not just money growth that has decelerated; credit growth too is now much lower, with total social financing excluding equity issuance only growing at 10.5%, also its lowest level on record (Chart I-6). Chart I-5The CNY Is Much Weaker ##br##Than The DXY Implies Chart I-6Chinese Monetary And Credit ##br##Conditions Remain Tight Second, this tightening in financial conditions is having a real impact. As Chart I-7 illustrates, corporate spreads in China are currently rising significantly. This is causing borrowing rates to increase, despite a fall in government bond yields. Additionally, the price action in Chinese shares suggests that an important slowdown in manufacturing PMIs could soon materialize (Chart I-8). Beijing will be reluctant to see PMIs fall below 50, as the chart implies. Chart I-7Chinese Corporate Spreads: ##br##Material Widening Chart I-8A Shares Imply Serious ##br##Economic Downside So why is the RMB a useful lever to use at the present juncture, rather than the usual monetary tools historically favored by Beijing? First, not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes, as evidenced in Chart I-9. Second, a weaker CNY versus the USD is historically consistent with a cut in the Reserve Requirement Ratio (RRR), which has already been implemented by the PBoC (Chart I-10, top panel). Moreover, the Chinese current account fell into deficit last quarter (Chart 10, bottom panel). Not only does a lower RMB help deal with this issue, but the PBoC may be forced to cut the RRR further if the deficit remains in place, as it drains liquidity from the banking sector. Chart I-9China Needs A Buffer Against Slowing Trade Chart I-10Supportive Conditions For A Lower CNY Third, in recent months, China's official forex reserves have been experiencing a series of outflows (Chart I-11). A depreciated exchange rate short-circuits this phenomenon, as once the CNY has fallen the expected returns from further shorting the currency collapses, curtailing incentive to bring money out of the country. Fourth, the trade-weighted yuan - both the J.P. Morgan measure as well as BCA's export-weighted basket - is still at elevated levels (Chart I-12), implying that the currency can still be used as a relief valve to stimulate the economy. Chart I-11Chinese Forex Reserves Experiencing Outflows Chart I-12The CNY Has Scope To Fall Finally, depreciating the yuan is a way of creating some support under the Chinese economy without compromising the goals of deleveraging and reforms. Traditional monetary stimulus would only encourage a debt binge; however, a lower exchange rate will help profits, prevent too-steep a fall in producer prices, and support employment. Moreover, even if the current decline in foreign exchange reserves indicates that capital outflows have not been completely staunched, the severe capital controls implemented since 2015 limit the risk that outflows accelerate from here. When the PBoC engineered its first depreciation of the yuan that year on August 11, investors and Chinese citizens began to expect more weakness, and yanked funds out of the country. The ensuing hit to the monetary base meant that monetary conditions remained tight, despite the PBoC efforts. This is unlikely to happen again. Chart I-13Timid Fiscal Support, So Far To be fair, a weaker currency is not the only tool that China can use to reflate its economy. Fiscal stimulus is another one that is not too out of line with the deleveraging objective for the private sector, provinces, municipalities and state-owned enterprises that Beijing has in mind. So far, the Chinese central government has not used this lever with much alacrity this year (Chart I-13). However, we expect fiscal policy to be used more aggressively as the year progresses. Nonetheless, this is unlikely to preclude Beijing from using the exchange rate as a key tool to support the economy. Bottom Line: China is likely to continue to target a lower CNY in order to put a floor under its economy, especially as the risk of a trade war with the U.S. becomes more real. Not only is a lower exchange rate a way to reflate the economy that does not conflagrate too violently with the stated desire to continue to deleverage, it is also a way to insulate the economy against a slowdown in global trade. 2018 is also a better environment for China to use the exchange rate as a lever than was the case in 2015, since the capital account is under tighter controls than it was back then. Finally, it is likely that exchange rate policy will be supplemented with fiscal supports. Investment Implications In an environment where liquidity is getting scarcer and where trade wars and protectionism are a real threat, a weaker yuan would be likely to exacerbate these fears. As a result, we judge that the template created by the 2015 devaluation remains relevant. As Table I-1 illustrates, in 2015, the euro did not fare particularly well when the yuan was devalued. However, its performance was not atrocious either. Back then, investors entered the devaluation with large short bets, and the euro was slightly cheap on our short-term models. This time around, speculators are still long the euro - albeit less so than they were in April - and the euro still trades at a small premium to its fair value. Table I-1A Weaker CNY Helps The Yen, ##br##Hurts The Rest However, Table I-1 also shows that the yen significantly benefited during this episode. While we would expect the yen to once again perform well if the CNY were to fall more, we doubt it would rally as strongly as it did in 2015. Simply put, back then the yen traded at a massive discount to its fair value, and investors were very short. Today, the yen is roughly fairly valued and short positioning is much more modest. The AUD, CAD and NOK also suffered significant declines during the last episode. Valuations and positioning in the AUD and the CAD are today very short, but they were also very short in 2015. Ultimately, a lot will have to be gleaned from the dynamics in Chinese monetary conditions. If the DXY moves to our target of 98, USD/CNY will need to move to 7.1 or above for Chinese monetary conditions to stabilize. This means that Chinese monetary conditions could deteriorate further before finding a floor. As Chart I-14 illustrates, this in turn suggests the AUD, CAD and EUR have significant downside from current levels. Moreover, if the CNY were to fall to USD/CNY 7.1, investors would rightfully be concerned about even more trade sanctions from the U.S. After all, this opens the door to China being labeled a currency manipulator, a move that could be met with additional retaliatory actions by China. However as Chart I-15 illustrates, the euro and the pound are very sensitive to global trade penetration. If investors were to discount further protectionisms and thus a further decline in global trade, they could therefore sell the pound and the euro in the process. This conflict between Chinese monetary conditions and trade protectionism creates a catch-22 situation for the currency market, one that is most likely to be resolved in a higher USD, and more volatility in assets linked to EM. Our highest conviction recommendation to play these dynamics remains to be short EUR/JPY. Not only do the economics behind this trade are consistent with fears of global protectionism (Chart I-15, bottom panel), but the technical picture also remains attractive. As Chart I-16 shows, both EUR/USD and USD/JPY have failed against important resistances, which have been translated in an echoing message in EUR/JPY itself. An interim target at 120 make sense right now. Chart I-14Chinese Monetary Conditions##br## Point To USD Strength Chart I-15Fears Of Protectionism ##br##And The FX Market Chart I-16Favorable Technicals To Stay ##br##Short EUR/USD And EUR/JPY The USD/CNY has already made a significant move, from an intraday low of 6.25 on March 27 to nearly 6.62. It is thus likely that Chinese authorities take a break from the devaluation campaign before pushing the CNY lower again, especially as 6.65 constituted a temporary equilibrium level during the fourth quarter of 2018. This therefore means that the dynamics described above could play out over the remainder of the year. Bottom Line: A weaker CNY is likely to give some spring to an already strong U.S. dollar. Moreover, FX markets are facing a tough dichotomy. To stop the strength in the dollar against the majors, the yuan needs to fall enough to cause Chinese monetary conditions to find a floor. This requires a USD/CNY at 7.1. However, at such a level, investors are likely to become very worried about even more trade protectionism out of the U.S. Yet, fears of declining global trade also favor a stronger dollar. We therefore expect the dollar to have some additional upside, and we anticipate EUR/JPY will experience significantly more downside from current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Core and headline durable goods orders both contracted by 0.3% and 0.6%; Pending home sales also contracted by 0.5% in monthly terms, and 2.2% in yearly terms; GDP growth disappointed expectations, coming in at a 2% annualized growth in Q1. The greenback's ascent continues, with the DXY recouping nearly half of its losses since its peak at the beginning of 2017. The broad trade-weighted dollar is back at March 2017 levels. A flattening yield curve and increasing protectionism are causing turmoil in risk assets, boosting the greenback as a result. As the Fed continues to unwind its balance sheet, the shortage of dollars is likely to continue to hamper global risk-taking and propel the greenback even further. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been decent: French and German Manufacturing PMIs disappointed, while Services and Composite PMIs outperformed; German IFO Expectations beat expectations, while the Current Assessment component decreased; European money supply growth increased by 4% on an annual basis; Italian inflation came in at 1.4%, higher than the expected 1.3%; German headline and harmonized inflation dropped by 100 bps to 2.1%, in line with expectations. European data has been dragged down by waning global growth. The rising protectionism acts as a further handicap to Germany's export-oriented economic model. In his last speech, ECB President Draghi confirmed the ECB's dedication to achieving its inflation target. He also provided more clarity regarding the outlook for interest rates, arguing that they can remain at current levels "for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations." As the possibility of further dovishness remains, the euro's depreciation is likely go on, especially with an environment of rising protectionism. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: The Leading Economic Index outperformed expectations, coming in at 106.2. Meanwhile, the Nikkei Manufacturing PMI surprised to the upside, coming in at 53.1. Finally, the National Consumer price index yearly growth also outperformed expectations, coming in at 0.7%. USD/JPY has been relatively flat this past two weeks, as the impact of the strength in the dollar has been neutralized by risk-off sentiment linked to the sell-off in Emerging markets and to the escalation of global trade tensions. We believe that the yen will continue to have upside this year, particularly against the euro, as trade tensions will continue to escalate, and as policy tightening in China will further hurt risk-assets. Safe heavens like the yen will benefit in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been improving: Nationwide housing prices yearly growth came in at 2%, outperforming expectations. Moreover, public sector net borrowing also surprised positively, coming in at GBP3.356 billion. Finally, BBA Mortgage approvals also surprised to the upside, coming in at 32,244. GBP/USD has fallen by nearly 1.5% the past two weeks. Overall, we continue to believe that cable will have short term downside, given that the dollar is likely to continue its rise. Nevertheless, the pound is likely to outperform the euro, as Europe is much more levered to the Chinese industrial cycle than the U.K. This means that if China continues to tighten, the European economy will underperform, hurting EUR/GBP in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Aussie has been hit by President Trump's increasingly aggressive stance towards global trade and by the already evident slowdown in global trade. With tariffs implemented on Australia's largest trade partner, China. Additionally, the domestic economy is making matters worse, as it is still rife with substantial slack. As a result, the RBA has remained on the sidelines, especially as it is worried by the impact of higher interest rates on an overvalued housing market and dangerously indebted households. We expected the AUD to suffer further against all other G10 currencies, as it remains expensive and is the most exposed to China's economy. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Both exports and imports outperformed expectations, coming in at NZD5.42 billion and NZD5.12 billion respectively. Moreover, the trade deficit also surprised positively, decreasing to NZD3.6 billion. Finally, GDP yearly growth came in line with expectations at 2.7%. NZD/USD has fallen by nearly 2.5% over the past two weeks. This has been in part due to the sell-off in emerging markets as well as escalating global trade tensions. The New Zealand economy is a small open economy that is highly levered to global trade, making the NZD very sensitive to these risk factors. We continue to be bearish on the kiwi in the short term, as trade tensions persist, while tightening in China will continue to weigh on high yield assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 In his speech on Wednesday, Governor Poloz did not address the shortfall in economic data that came out last week: Headline and core retail sales contracted by 1.2% and 0.1% in monthly terms, respectively, underperforming expectations; Headline inflation stayed steady at 2.2%, albeit less than the expected 2.5%; Core inflation fell to 1.3% from 1.5%, and less than the expected 1.4%. Instead, he mentioned that the Bank of Canada is incorporating into its reaction function the effects of the tariffs imposed by the U.S. on Canada and the rest of the world. This message received more attention than his confirmation that "higher interest rates will indeed be warranted" as the CAD weakened throughout his speech, and the odds of a rate hike on July 11 dropped from 80% to 50%. Recent news has also surfaced regarding possible Canadian quotas on steel imports from the rest of the world in an effort to circumvent dumping activities by Chinese officials. Aggravating protectionism represents a very real risk for the CAD and the very open Canadian economy. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The SNB left their policy rate unchanged at -0.75% in their latest policy meeting. Overall, we continue to be bearish on the Swiss franc on a long term basis, given that economic activity and inflationary pressures are still too weak in Switzerland. This will force the SNB to continue with its ultra-dovish monetary policy designed to limit the CHF's cyclical upside. Recent comments of SNB board member Andrea Maechler confirm this, as she stated that the Swiss franc remains "highly valued" and that while they are content with inflation in positive territory, "inflation remains low". Nevertheless EUR/CHF should depreciate on a tactical basis, given that Chinese deleveraging and escalating trade tensions will sustain the current risk-off period, helping safe heavens such as the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rallied by roughly 0.7% this past week, despite surging oil prices. The rise in the dollar, as well as the generally risk-off environment has neutralized the rise in oil prices caused by the recent large draw in inventories. Our commodity strategist expect oil to keep rising in the face of tighter supply caused by OPEC members. This will help the NOK outperform other commodity currencies like the AUD and the NZD. However, USD/NOK is still likely to rally in the face of a tightening fed, as the USD/NOK is more sensitive to interest rate differentials than to oil. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data has been decent: The unemployment rate dropped to 6.5% from 6.8%, in line with expectations; Consumer confidence, however, was lower than the expected 99.8, coming in at 96.8; Producer price inflation came in at 6.3%, beating expectations of 4.9%; Retail sales grew annually at 3.1% in May, less than the previous 3.3%; The trade balance saw another deficit of SEK 2.6 billion, but improved from the previous deficit of SEK 6.1 billion The krona likely has substantial upside this year, especially against the euro. Given that inflation data has been in line with the Riksbank's target, it is likely that the central bank will draw back some of its monetary accommodation, which would realign the krona with its underlying growth fundamentals. The krona has once again started to weaken against the euro, reflecting investor angst in the face of global protectionism. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Chart 7U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 20China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Chart 23Trade In Intermediate Goods Dominates This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 27Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Chart 32The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap Chart 37When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 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. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Appendix B Chart 1Market Outlook: Bonds Appendix B Chart 2Market Outlook: Equities Appendix B Chart 3Market Outlook: Currencies Appendix B Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades