Economy
Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Does the 3% level on Treasuries matter to investors? The 2/10 yield curve is typically much steeper when global growth is strong and pro-growth policies are in place. The imperfect inter-relationship between labor market slack, wages and inflation. Feature In last week's report1 we noted that the risk of weakness in equity markets was elevated in the near term. Risks assets balked as the 10-year Treasury yield climbed above 3% early last week. However, easing tensions on the Korean peninsula and another stronger than expected batch of Q1 earnings reports boosted U.S. equity prices later in the week. We will provide a full update on the Q1 earnings season in next week's report. Investors are getting used to a seasonal dip in Q1 U.S. GDP data, and last Friday's release certainly fits the bill. A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this seasonal anomaly are in the private investment and government consumption components of GDP. Output in both categories slowed significantly in Q1 2018. Consumer spending growth exhibited the most significant slow-down, growing at only 1.1% compared to 4% in the prior quarter. But growth in investment spending on equipment also declined sharply, from 11.6% to 4.7%, as did growth in residential investment, from 12.8% to 0% (Chart 1). The latter is due to the sharply accelerating input costs (e.g. lumber prices) faced by homebuilders at the moment. Federal government spending slowed to a 1.7% rate in Q1 from 3.2% in Q4 2017. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target At 2.9% year-over-year in Q1 2018, real economic growth was above the Fed's view of potential GDP (1.8%) for the fifth consecutive quarter. Given the recent seasonal pattern and the substantial fiscal stimulus coming on stream, the Fed will likely see through the weaker Q1 growth data for the time being. Chart 2Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's view is that the 3% level on the 10-Year Treasury yield is not an impediment to higher equity prices. The 10-year yield and U.S. equity prices climbed together in the 1950s. The rise in yields in the '50s primarily reflected better economic growth rather than fears of inflation. The run-up in yields since the lows last year reflect both factors (Chart 2). Nonetheless, investors are concerned that higher yields will flip the positive correlation between bond yields and stock prices. Charts 3 and 4 shows the link between the level of both nominal (Chart 3) and real bond yields and equity prices. The implication is that the relationship between stock prices and bond yields tends to stay positive when the nominal bond yield is below 5%. Furthermore, the correlation between real yields and stock prices remains positive (Chart 4). Moreover, since 1980, a move from 2% to 3% on the 10-year Treasury yield has been accompanied by an average gain of 1.2% in the S&P 500, with a median move of 1.8%.3 On average, the S&P 500 posted a modest decline (24 bps) as the 10-year Treasury elevated from 3% to 4%, but the median return (98 bps) was still positive. Our July 2015 Special Report4 explored the impact of rates and inflation on equity prices. Historically, even the move from 4% to 5% on the 10-year is not an impediment to higher stock prices. Chart 3Stock To Bond Correlations Remain Positive With Nominal Yields Below 5% Chart 4Both Equities And Real Bond Yields Reflect Growth Bottom Line: BCA's stance is that the stock-to-bond ratio will climb this year. Our U.S. Bond Strategy team pegs fair value on the 10-year at 2.78%, but notes that the yield may peak this cycle at between 3.25% and 3.50%.5 BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until at least mid-2019 and that increasing bond yields are not a threat. Yield Curve Dynamics Does BCA's stance on the yield curve change our upbeat view on risk assets beyond the next few months of caution?6 In March,7 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. Although global growth has peaked,8 we expect the era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.9 The curve should resume its flattening trend after that, but will not invert this year. The 2/10 curve stands at 45 bps as of April 27, 2018. Chart 5 shows that the curve has spent very little time in the 0-50 range in the past 35 years when fiscal, monetary and regulatory factors were aligned and global growth was positive. A steeper curve (50 to 100 bps) developed alongside a pro-growth policy and solid global growth only once in the past 35 years, over 1983 and 1984, and never when the 2/10 curve was between 0 and 100 bps (not shown). Chart 5The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place Bottom Line: The backdrop of accommodative fiscal and monetary policy, attended by easing regulatory policy and positive global growth, will continue to provide a tailwind for risk assets through next year. However, the 2/10 yield curve is typically much steeper when these policies are all aligned. Thus, investors should continue to favor equities over bonds and remain underweight duration over the cyclical horizon with a tactical cautious stance over the next few months. The Wage Puzzle Chart 6Economy At Full Employment, Theoretically The move higher in the 10-year Treasury yield to 3% for the first time since 2013 (and the 2-year Treasury to 2.5% for the first time since 2008) has diverted attention to the Fed and inflation. Core CPI is now at the Fed's 2% target and the market is concerned that inflation will shoot past 2% and quickly escalate to 3%. BCA's view is that inflation will remain at the Fed's target this year, but drift above that goal in 2019, which would elicit a more aggressive response from the central bank. Tighter monetary policy will ultimately end the expansion in early 2020.10 Until then, the markets will focus on the drivers of inflation, including wages. Our work11 notes that inflation is slow to turn higher in long expansions. The U.S. economy reached full employment in late 2016 (Chart 6). In short- and medium-length expansions, it takes only a few months before inflation turns up. However, in long expansions (1960s, 1980s, and 1990s) prices did not turn meaningfully higher until 26 months after the economy reached full employment. This suggests that a more significant hike in inflation - led by a tighter labor market - is close and supports the recent rise in Treasury yields. There is mixed evidence that view is warranted. Wage inflation has moved higher in recent months, but the link between wages and prices has weakened. Chart 7 shows that before 1985, the correlation between wage growth and prices was above 90%. Since 1984, the relationship has waned. The post-1985 correlation is just under 30%. BCA expects this weaker relationship to persist. Chart 7Link Between Wage Inflation And Consumer Inflation Changed After 1985 The disconnect between labor market tightness and wages has recently widened. Chart 8 shows several measures of wage pressures and labor market slack. Historically, less slack translates into higher wages, but the relationship in this cycle has been muted. Moreover, pay gains for workers who switch jobs are running well ahead of those who stay in their current positions and are either promoted or given merit raises (Chart 9). The gap between compensation gains of job switchers and job stayers tends to broaden as the business cycle ages and slack in the labor market shrinks. Chart 8A Wide Disconnect Between Labor Market Slack And Wage Gains Chart 9Job Switchers Seeing Better Raises Demographics and wage rigidity dynamics are also at play. Chart 10 shows that the labor force participation rate is headed lower due to demographics, but recent trends suggest there may be improvements in the coming years. BCA's view is that the participation rate will be flat in the next 12 months and move lower in the coming decade. Chart 10Decline In Labor Force Participation Is Mostly Demographics Wage inflation is an early career phenomenon. Recent research from the Federal Reserve Bank of New York12 shows that across all education cohorts, rapid real wage growth occurs early in a worker's career, with positive real wage growth ending in his/her forties. This is followed by a period of flat to declining real wages. By age 55, all education categories experience negative real wage growth, on average (Chart 11). Chart 11Wage Inflation Is An Early Career Phenomenon Wage rigidity in this cycle suggests that there will be an upward correction in labor compensation. Chart 12 shows that 14.5% of workers did not have wage increases in 2017. Moreover, 18.9% of hourly workers and 9.2% of non-hourly workers saw no increase in pay in the year ending in December 2017 (Chart 13, top panel.) The bottom panel of Chart 13 shows that more than 20% of workers with less than a high school education received no pay increases in the past year; only 10% of college-educated workers experienced the same end. It is important to note that on balance, measures of wage rigidity have increased over time and are not overly sensitive to the business cycle. Chart 12More Than 14% Of Workers Didn't See A Raise In 2017 Chart 13Wage Rigidity By Type Of Employee Bottom Line: BCA recommends that investors monitor a broad range of inflation indicators. Historical evidence suggests that when the labor market tightens, inflation eventually accelerates. However, wages do not always lead inflation at bottoms and maybe a lagging indicator in this cycle.13 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. Most of these indicators show that inflation pressures are building, but only gradually. We expect the Fed to raise rates gradually in the next 12 months, but it may turn more aggressive in 2019 as pressures on inflation, driven in part by a tighter labor market, begin to mount. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 2 https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201706-lingering-residual-seasonality-in-gdp-growth.aspx 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Yellen's Last Week," published February 5, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report, "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Report, "It's Still All About Inflation", January 16, 2018. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", March 12, 2018. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Peril?", April 9, 2018. Available at usis.bcaresearch.com. 9 Please see BCA U.S. Bond Strategy Weekly Report, "Back To Basics", April 17, 2018. Available at usbs.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000", published March 30 2018. Available at gis.bcaresearch.com. 11 Please see BCA Research's The Bank Credit Analyst Monthly Report, March 2017. Available at bca.bcaresearch.com. 12 FRBNY: Liberty Street Economics, "U.S. Real Wage Growth: Slowing Down With Age," September 28, 2016. 13 Please see BCA Research's The Bank Credit Analyst, September 2017. Available at bca.bcaresearch.com.
Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Chart 10Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Chart 14Softening Demand Chart 15Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)
Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey Chart 17Only The Best Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Both the euro's undervaluation and the euro area's massive trade surplus constitute disequilibria, which cannot persist in the long term. Hence, the trade-weighted euro will structurally appreciate... ...and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Feature Yanis Varoufakis, the former Finance Minister of Greece, recently highlighted EU institutions' obsession with protecting their credibility at all costs. Once set on a course, EU institutions tend to suffer a blinkered tunnel-vision. A big fan of Shakespeare, Varoufakis likened this resistance to change course - no matter the repercussions - to Lady Macbeth's declaration that "what's done cannot be undone."1 As Mario Draghi prepares to take the stage again, we recall the final line of his last performance on March 8 as an echo of Lady Macbeth. Asked to justify the ECB's obsession with the 2 per cent inflation point-target, Draghi declared that "there are serious costs about changing course on credibility". We fully understand the ECB's desire to protect its credibility. The trouble is that it is set on a course that is incredibly difficult to accomplish: a single mandate to sustain a 2 per cent inflation point-target, based on a consumer price basket that omits one of the largest items of household expenditure - housing itself. Chart of the WeekAs The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Euro Area Inflation Is Running Higher Than The HICP Suggests Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses. Which makes the omission of this cost from the euro area Harmonized Index of Consumer Prices (HICP) completely ludicrous. Using the experience of U.S. inflation which does include owner occupiers' housing costs, we estimate that a price basket that correctly included home maintenance costs would outperform the HICP by an average of 0.5 percentage points a year (Chart I-2). Chart I-2Including Owner Occupiers' Housing Costs ##br##Adds 0.5% To Inflation Recognizing this error, the U.K.'s Office For National Statistics recently changed its main inflation index from the Consumer Prices Index (CPI) to the Consumer Prices Index including owner occupiers' housing costs (CPIH), acknowledging that "the costs of housing services associated with owning, maintaining and living in one's home are an important component of household expenditure that are not included in the CPI... Therefore the CPIH is the most comprehensive measure of inflation." We expect the BoE's target for 2 per cent inflation to switch eventually to the CPIH too, albeit it remains the CPI for the time being. However, a 1 to 3 per cent 'variation band' around the CPI inflation target does give the BoE considerable breathing space. By comparison, the ECB's target for 2 per cent inflation excluding owner occupiers' housing costs and excluding a variation band gives it a significantly more difficult task than its peer central banks. The crucial point is that the ECB's ultra-loose policy is to a large extent a function of a tunnel-vision pursuit of an HICP inflation rate which significantly understates true inflation. As true inflation is higher than suggested, it means that true real interest rates are lower than suggested. And as currency markets feel true real interest rate differentials - rather than those derived from the faultily constructed HICP - it means that markets have undervalued the euro. This has resulted in an over-competitive euro area, and a massive trade surplus (Chart I-3). Chart I-3The Euro Area Trade Surplus Is A Mirror-Image ##br##Of The Undervalued Euro Both the currency undervaluation and the associated trade surplus constitute disequilibria, which cannot persist in the long term. We have no strong conviction for the very near term move in the euro, but there are two longer term implications: the trade-weighted euro will structurally appreciate by about 10%; and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart of the Week). Japanese Lessons For Europeans: The Homework A few weeks ago in Japanese Lessons For Europeans we made some counterintuitive observations about Japan's post-bubble economic experience.2 Most notably, we showed that on a real GDP per head basis, Japan has outperformed every other major economy over the past twenty years. Our finding was based on real GDP divided by working age (15-64) population because we wanted to capture real productivity gains - which rely mainly on the productive population. The counterintuitive finding elicited a couple of questions. One question was whether the result changes if we were to divide by the total population rather than the working age population. The answer is, not really. Dividing by total population, Japan would no longer be top of the leader board, but the broad result would still hold. Japan has performed impressively, and we fail to see the so-called 'lost decades' (Chart I-4 and Chart I-5). Chart I-4Japan Has Performed Impressively On ##br##Real GDP Per Working Age Population... Chart I-5...And Real GDP Per##br## Total Population Still, some people pointed out that Japan's public indebtedness now equals 210% of its GDP, up from 120% at the start of the century. So a second question was whether Japan's impressive performance is entirely due to its fiscal largesse. The answer is, not exactly. What matters is the change in total indebtedness - public plus private. As a share of GDP, public indebtedness is up by 90% but private indebtedness is down by 40%. So total indebtedness is up by 50% of GDP, considerably less than the increases elsewhere in the developed world. For example, over the same period, the U.K.'s total indebtedness is up by 100% of GDP. Moreover, even the level of Japan's total indebtedness as a share of GDP - at 370% - is not that different to other major economies. In Belgium, it is 340%; in France it is 305%; in Canada it is approaching 300% (Charts I-6-Chart I-17). Chart I-6Japan: Total Debt Up From 315% ##br##To 370% Of GDP Chart I-7U.S.: Total Debt Up From 185% ##br##To 250% Of GDP Chart I-8Canada: Total Debt Up From 225%##br## To 290% Of GDP Chart I-9Australia: Total Debt Up From 150% ##br##To 235% Of GDP Chart I-10U.K.: Total Debt Up From 180%##br## To 280% Of GDP Chart I-11Switzerland: Total Debt Up From 245%##br## To 270% Of GDP Chart I-12Germany: Total Debt Down From 185%##br## To 180% Of GDP Chart I-13France: Total Debt Up From 190%##br## To 305% Of GDP Chart I-14Italy: Total Debt Up From 195%##br## To 265% Of GDP Chart I-15Spain: Total Debt Up From 165% ##br##To 270% Of GDP Chart I-16Belgium: Total Debt Up From 260% ##br## To 340% Of GDP Chart I-17Sweden: Total Debt Up From 210% ##br##To 275% Of GDP Public Sector Leveraging Must Counterbalance Private Sector Deleveraging People who take on debt tend to be young, while those who pay down debt tend to be older. As population pyramids in developed economies shift to older cohorts, there are fewer people who wish to take on debt and more people who wish to pay it down. Specifically, the 50-70 age cohort tends to use pre-retirement income and retirement lump-sum payments to extinguish any outstanding mortgage debts. Consider an older person with an income of €1000 who wishes to pay down €100 of debt. It follows that the person will spend €900. Ordinarily, the banking sector will then reallocate the paid-down €100 to, say, a younger person who wants to borrow it. When the borrower spends the €100, aggregate expenditure totals €1000, which equals the original income. And all is well and good. However, in a world where there is an excess of people who wish to pay down debt versus those that wish to borrow, it might not be possible to reallocate the paid-down €100 to a new borrower in the private sector, even with interest rates at ultra-low levels. In this case, the only way to prevent a contraction in expenditure - a recession - is if the government steps in to borrow and spend the aforementioned €100 to keep the economy's expenditures at €1000. Moreover, because the private sector is paying down debt, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. The above illustration describes the structural situation in many developed economies at the moment. And it explains why we should not look at the evolution of indebtedness in the public sector and the private sector separately, but rather in combination. This is another important Japanese lesson for Europeans. A final observation is that if the private sector is deleveraging, private indebtedness as a share of GDP tends to drift lower. This necessarily means that banks total assets' are growing slower than overall sales in the economy. As banks' asset growth is their main driver of long-term profit growth, it also means that banks struggle to outperform the market on a sustained basis. This has been the experience in Japan since 1990 and in the euro area since 2008 (Chart I-18). Chart I-18When The Private Sector Pays Down Debt, Banks Structurally Underperform With private indebtedness declining as a share of GDP in many major economies, we conclude that banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From Yanis Varoufakis's 2018 Rose Shakespeare Lecture. 2 Please see the European Investment Strategy Weekly Report "Japanese Lessons For Europeans" April 5, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a mixed week for our trades. Long USD/ZAR is approaching the end of its 3 month maximum holding period comfortably in profit. Against this, the recent intense volatility in the metals market closed the pair-trade long lead/short nickel at its stop-loss. We are not initiating any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-19 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios Table I-410-year Treasury Return Scenarios We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth Chart I-6U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) Chart I-8BIMF Projections (II) U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... Chart II-14...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Table 1Exit Checklist Table 2Protectionism: Upcoming Dates To Watch Chart 2Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Chart 6Beige Book Commercial##BR##Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book