Economy
Highlights China's tightened control on capital account transactions has played a key role in slowing down capital outflows, particularly outward FDIs. Meanwhile, investors' panic over the RMB has also abated substantially, likely due to a combination of greater policy transparency and improved growth conditions. The PBoC's capital account control measures will not be permanent. Cross-border capital flows are by nature volatile and highly pro-cyclical, while China's capital account control measures are imposed as a counter-cyclical mechanism. The stabilization in China's official reserves is accompanied by a notable setback in the RMB's internationalization process. The internationalization of the RMB will resume, but it is impossible to challenge the role of the dollar as the world's dominant reserve currency in the foreseeable future. Feature Chart 1The Decline In Chinese Official Reserves##br## Has Halted Amid recent soft growth numbers, an important positive development is that official foreign reserves in China have been increasing for six consecutive months, which is being perceived as a sign of the country's re-gained macro stability (Chart 1). A closer look at China's foreign reserves and balance-of-payment statistics suggests capital outflows have slowed considerably. Confidence in the RMB appears to have improved, but expectations of further RMB depreciation have not completely reversed. This means capital outflows may still accelerate, especially if the dollar bull market resumes.1 The RMB internationalization process has also suffered a notable setback in recent quarters due to investors' weakened confidence in the currency. The RMB will continue to gain broader adoption beyond China's borders over time, but the process will be gradual and hesitant, and it will not challenge the mighty dominance of the U.S. dollar anytime soon. Capital Flows: What Has Changed? Chinese official reserves have stabilized around US$3 trillion since early this year, bottoming from a prolonged decline from a peak of over US$4 trillion in mid-2014. The broad dollar weakness in recent months has boosted the value of Chinese official holdings of non-dollar assets, which has helped stabilize the level of overall reserves. Nonetheless, the country's balance-of-payment data shows major changes in the patterns of cross-border capital flows, yielding some important information. Chart 2Inward Portfolio Investment Has "Normalized" In terms of capital inflows, the messages are mixed (Chart 2). On one hand, portfolio inflows have rebounded sharply since the second quarter of 2016 after a deep decline in the previous three consecutive quarters. Foreign investors aggressively pulled out of Chinese markets, particularly bonds, between the third quarter of 2015 and the first quarter of 2016, spooked by the People's Bank of China's surprise moves to devalue the RMB in August 2015 and in January 2016. It appears that foreign investors have become more comfortable with the RMB's "new normal" in recent quarters. Foreign purchases of Chinese onshore bonds have largely returned to normal, but stock purchases have remained subdued compared with previous years. The dramatic boom-bust in the Chinese domestic stock market in 2015 also dampened foreign investors' appetite towards this volatile asset class. It remains to be seen whether the newly established "bond connect" program and the MSCI's recent decision to include A shares in its indexes will be able attract more foreign portfolio investors. On the other hand, foreign direct investment (FDI) inflows have continued to decline. Inbound FDI dropped to a mere US$21 billion in the last quarter, near the levels at the height of the global financial crisis (Chart 3). FDIs are largely strategic decisions and are less influenced by near-term exchange rate fluctuations. Therefore, the sharp decline in FDI is a worrying sign that foreign investors' confidence in the Chinese business environment has weakened significantly, which is consistent with numerous surveys that show a gradual drop in China's ranking in global company's investment plans (Chart 4). For the Chinese authorities, how to improve the country's business environment and re-gain investors' confidence should be taken much more seriously. Chart 3FDI Has Fallen Sharply Chart 4China Is Losing Lure Among Global Firms On capital outflows, all channels have slowed of late, which is the key reason behind the stabilizing official reserves. Outbound FDI has fallen sharply since the fourth quarter of 2016 (Chart 5). Corporate China's overseas investments averaged almost US$60 billion for six consecutive quarters between the third quarter of 2015 and the fourth quarter of 2016, and has dropped to less than US$20 billion in the past two quarters. Repayment of overseas liabilities by the corporate sector, another major reason for capital outflows in previous years, has also slowed substantially (middle panel, Chart 5). Corporate China's deleveraging of dollar debt quickened sharply in 2015, as the RMB began to fall against the dollar. It has eased considerably of late, either due to re-gained stability of the exchange rate or as the deleveraging process has become advanced. The balance-of-payment statistics shows that total outstanding foreign loans and trade credit currently stand at US$620 billion, down from a peak of over US$1 trillion in the second quarter of 2014. Rampant "hot money" outflows in previous quarters have reversed recently (bottom panel, Chart 5). In fact, inbound "currency and deposits," which we label as "hot money," as it is most liquid and historically has been highly volatile, have reached a new record high. Taken together, the Chinese regulators' tightened rein on capital account transactions have clearly played a key role in slowing down capital outflows, particularly outward FDIs. Meanwhile, investors' panic over the RMB has also abated substantially, likely due to a combination of greater policy transparency and improved growth conditions. In essence, cross-border capital flows are by nature volatile and highly pro-cyclical, while China's capital account control measures are imposed as a counter-cyclical mechanism to regulate capital flows. In this vein, the PBoC's capital account control measures will not be permanent - they will be eased as capital outflows ease. It is important to note that China still runs a current account surplus, which means the country, public and private sectors combined, is still accumulating net foreign assets. Chart 6 shows that China's official reserves have declined substantially from their 2014 peak, but the country's total foreign assets have continued to climb - an indication that the private sector has been taking a greater share in the country's total foreign claims. For years, the PBoC's key challenge was to persuade the private sector to hold more assets in foreign currencies, and the trend has suddenly changed in recent years. It is wrong, however, to assume that the change is permanent. Chart 5Capital Outflows Have Eased Significantly Chart 6Private Sector Is Taking A Greater Share ##br##Of China's Foreign Claims The RMB Internationalization Scorecard Chart 7Setback In The RMB Internationalization Process The stabilization in China's official reserves is accompanied by a notable setback in the RMB's internationalization process. Measured by two key functions of money, the role of the RMB as an international currency has declined. As a medium of exchange, the RMB's role in cross-border settlement has dropped sharply (top panel, Chart 7). Currently the RMB accounts for about 15% of China's foreign trade settlement, down from over 30% at the peak of early 2016. The RMB's share as an international payments currency dropped to 1.98% in July, down from 2.45% in January 2016, according to SWIFT. The share of the RMB as a trade settlement currency has also stabilized in recent months, as the RMB exchange rate has stabilized. As a store of value, the RMB's role has likely also dropped, particularly among private investors, as evidenced by the sharp decline in RMB deposits in Hong Kong (bottom panel, Chart 7). Among official reserve managers, however, the role of the RMB may have begun to increase. The European Central Bank converted the equivalent of €500 million of its foreign reserves into RMBs in the first half of 2017. Since March 2017, the International Monetary Fund (IMF) has begun to include holdings of RMB in its currency composition of official foreign exchange reserves (COFER). The IMF identified US$88.5 billion of RMB-denominated official foreign reserve assets held by reserve managers in the first quarter of 2017, about 1% of total allocated reserve holdings (Table 1). From a big-picture perspective, the internationalization of the RMB will continue, even though the process will be hesitant and halting, with temporary setbacks. China is the largest trade partner of a growing number of countries with tightly-linked supply chains. This generates natural demand for RMB settlement in bilateral trade. In fact, the correlation between the RMB and the currencies of some of China's Asian neighbors has increased significantly in recent years, which is effectively creating a "RMB currency bloc" (Chart 8). Meanwhile, the Chinese government's ongoing "one-belt one-road" initiative involves financing for infrastructure in some less-developed countries, which will further boost demand for the RMB in these regions. All of this will inevitably broaden the reach of the RMB beyond China's borders. Table 1Composition Of Global Reserve Assets Chart 8The RMB Currency Bloc Nonetheless, it is impossible for the RMB to challenge the role of the dollar as the world's dominant reserve currency in the foreseeable future. The dollar's dominant status is not only supported by America's strong and open economy, but also by its deep, liquid and highly efficient financial markets, which are simply impossible for China to replicate anytime soon. The dramatic volatility in China's financial markets, regulators' shaky handling of the stock market boom-bust and the RMB's volatility in recent years are all indicative of a primitive financial infrastructure. China's legal and administrative frameworks will likely take even longer to converge to western standards. In short, the role of the RMB as an international currency will likely remain marginal for a long time. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights The strong labor market may be holding down wage inflation. The strength in sales and EPS is broad-based and sustainable. July FOMC minutes highlight internal debate at the Fed over inflation. Financial stability is the Fed's Third Mandate. Feature Risk assets struggled again last week but Treasury yields held steady as investors reacted to President Trump's latest controversy, the FOMC minutes, another round of solid economic data for Q3 and the final few earnings reports of the Q2 reporting season. The July FOMC minutes highlighted the internal debate at the Fed about the Phillips curve and financial stability. Nonetheless, we expect the Fed to continue to tighten policy later this year. In this week's report, we examine a study by the San Francisco Fed that highlights the negative impact of a strong labor market on wages. Profit margins continued to expand in Q2 and the BCA EPS model projects a solid 2H performance, driven by both domestic and globally oriented firms. Strong Labor Market, Weak Wages The labor market continues to tighten measures of overall labor market slack suggest that wage inflation should accelerate soon. Still, slack remains in some segments of the labor market and that may be depressing overall wage growth. The overall quit rate (2.1%) is slightly below its all-time peak and 65% of the 11 industry groups have quit rates that are at or close to pre-global financial crisis level (Chart 1). Moreover, fill rates, the ratio of hires to job openings, for most industries are at record lows, and job openings in all but the wholesale trade, information, mining & logging and construction areas have surpassed prior peaks (Chart 2). The implication is that economy-wide, there are more jobs seekers than jobs, which will ultimately force businesses to offer higher salaries. Chart 1Labor Market Strength Is Widespread... Chart 2...With Only A Few Industries Lagging Behind Moreover, wage pressures are mounting, especially for full-time employees. A recent study1 published by the San Francisco Fed found that at 3.4%, the year-over-year change in median weekly earnings was still below the 2007 peak. However, wage gains for continuously employed full-time workers (4.8%) are in line with rates seen a decade ago (Chart 3). Overall wage gains continue to be suppressed by new entrants to the labor force. Growth rates of median weekly earnings for this group are down 1.4%, and have been negative since the overall labor market began to recover in early 2010. The counter-intuitive implication of the SF Fed study is that substantial gains in the labor market may be depressing average wage rates. As individuals learn about better prospects for employment, they choose to join the workforce, either as new entrants (from school) or as reentrants (those who left either voluntarily or involuntarily). These groups, according to the study, have suppressed median weekly earnings growth by between 1.5% and 2.0% (Chart 4). Chart 3Wage Inflation Dragged##BR##Down By New Entrants Chart 41.5% To 2% Drag On Wage Inflation##BR##Due To Compositional Shifts In Workforce In addition, as 10,000 higher paid baby boomers reach 65 years of age each day and leave the labor force, they are replaced by lower wage earners. Bottom Line: The labor market is even tighter than the data suggests and the market's vigor may be understating wage inflation. Investors are mis-pricing the extent of rate hikes in 2017 and 2018. Bond yields are likely headed higher, but the stock market should take this in stride because of the favorable earnings backdrop. Corporate Profits Are Not Only A Weak Dollar Story EPS and sales growth in Q2 ran well ahead of consensus expectations as forecast in our July 3 preview. Moreover, the counter-trend rally in profit margins is still in place. So far, more than 90% of companies have reported results with 74% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 5). Furthermore, 69% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself, perhaps beginning early in 2018. Nonetheless, we saw another quarter of margin expansion in Q2. Average earnings growth (Q2 2017 versus Q2 2016) was strong at 12% with revenue growth at only 5%. The BCA Earnings model predicts EPS growth to hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured this way, S&P 500 EPS growth in Q2 will be 18%, compared with 13% in Q1. Chart 5Positive Earnings Surprises Continued In Q2 Chart 6Strong EPS Growth Expected In 2H '17 Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share were higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Energy revenues surged by 16% in Q2 versus a year ago. Sales gains in technology (8%), materials (7%) and utilities (6%), are notable. Moreover, year-over-year sales gains in Q2 2017 in all but three sectors (telecom, consumer staples and consumer discretionary) ran ahead of nominal GDP (+3.7%) in the same period. Investors will turn their attention to earnings prospects in 2H 2017 and 2018 as the Q2 reporting season ends. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (not shown) has been encouraging. The forecast for 2017 is 11.6%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. Similarly, the 2018 estimate (10.9%) is little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Like the financial markets, corporate managements have largely ignored President Trump during this earnings season. Trump's name was used only once in Q2 earnings calls held through August 11, down from 9 in Q1 calls and 32 in the Q4 2016 reporting season just after Trump took office (Chart 7). The single mention thus far matches the number of times that CEOs and CFOs cited Trump's name before last November's election. We are inclined to see fading concerns about government policy from the next Beige Book (due in early September) because Trump has managed to slow regulation2 during his first seven months in office, although uncertainty around the president's legislative agenda remains elevated. Table 1S&P 500: Q2 2017 Results* Chart 7Trump Fading As Topic On Earnings Calls BCA's case for improving profits in the second half of 2017 is supported by the August readings on the Empire State and Philadelphia Fed manufacturing indices, along with the June and July readings on industrial production (IP). IP has been a good proxy for sales of S&P 500 companies (Chart 8); a rollover in the 12-month change in IP would challenge BCA's constructive view towards earnings. However, strong readings on the ISM (July), the August Empire State and Philadelphia Fed indices suggest that IP should accelerate in the next six months. Moreover, the weaker dollar has boosted foreign demand for U.S. goods and services. The implication is that foreign demand (rather than domestic consumer or business spending) leads the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the IP indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 9). Chart 8Favorable Backdrop For Earnings And Sales Continues Into Q3 Chart 9U.S. IP Growth Still Lagging##BR##Other Developed Markets... Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, the weaker dollar has allowed profit and sales gains of globally oriented firms to rebound and outpace those of domestically focused businesses. (Table 2 and Chart 10) Margins for U.S. focused companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but are higher than margins of domestic companies. Chart 10Global EPS, Sales Playing Catch Up To Domestic Table 2Q2 Earnings Breakdown Bottom Line: EPS growth will continue to accelerate through 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth (Chart 6). The solid performance of manufacturing at home and overseas sets the stage for EPS growth in firms with both U.S. and global outlooks. BCA's bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. The Fed will not get in the way of the equity rally unless inflation suddenly surges in the coming months (which we do not expect). FOMC Debate Still Centers On Inflation The minutes from July's FOMC meeting indicates little progress on the debate over low inflation and the appropriate monetary policy response. It will require at least a modest rise in inflation to break the deadlock. Policymakers appear to be pleased with the state of economic growth, which has rebounded from a lackluster first quarter. They agree that the expansion will be strong enough that the labor market will continue to tighten. As highlighted in previous minutes, the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike, and how policy should adjust to changing financial conditions. A majority of policymakers seem willing to believe that this year's soft inflation readings are driven by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excessive risk-taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. Therefore, the hawks are anxious to resume tightening, despite the current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. If true, this would mean that the Phillips curve is very flat, or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. Some argued that the recent easing in financial conditions would add little to growth and thus, does not require tighter Fed policy. There was little movement toward capitulation by either camp evident in the minutes. Discussion of the Fed's balance sheet in the recent minutes reinforced that an announcement would likely occur in September, with tapering beginning shortly thereafter. "A number of participants" commented that financial conditions will be key to determining the pace of rate hikes. If the bond market and risk assets react negatively to balance sheet shrinkage, then it would be appropriate to slow rate increases to offset any economic repercussions. Given that only one rate gain is discounted in the money market curve over the next 12 months, it appears that investors are betting that balance sheet shrinkage will largely eliminate the need for higher short-term interest rates. Fed economists recently updated their quantitative assessments of FOMC minutes.3 The note provides a guide (Table 1 in the Fed paper) to the "quantitative words" used in the minutes (one, a couple, a few, etc.). We intend to comment on the findings of this paper in a future Weekly Report. An Update On The Fed's Third Mandate Financial stability remained a concern for Fed policymakers in July and that is why the hawks want to keep tightening even though inflation has not yet met the FOMC's target. BCA views "financial stability" as a third mandate4 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the July meeting by both Fed staff and voting FOMC members. Fed Chair Janet Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 20 of the 28 meetings she has presided over. Yellen will deliver a speech on financial stability on August 25 at the Fed's Jackson Hole conference. However, the Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in December 2013, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in 7 of the 13 subsequent meetings. FOMC participants have debated about financial stability at 4 of the 5 meetings this year, and 8 of the 11 since April 2016. As was the case at the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance in July.5 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. We conclude that the doves want inflation to rise closer to the 2% target before tightening again. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excessive risk-taking in markets according to some on the FOMC. Bottom Line: The FOMC minutes did not change our base case outlook: the FOMC will announce in September that it will begin to shrink the Fed's balance sheet. The next rate bump will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation will edge higher in the coming months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 http://www.frbsf.org/our-district/about/sf-fed-blog/wage-growth-good-news/?utm_source=frbsf-home-sffedblog-title&utm_medium=frbsf&utm_campaign=sffedblog 2 Please see U.S. Investment Strategy Weekly Report, "Still Waiting For Inflation,"August 14, 2017, available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 4 Please see 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/fomcminutes20170726.htm
Highlights The cyclical recovery in global earnings will trump, so to speak, ongoing political developments. Unlike the last three recessions, which resulted from burst asset bubbles, the next U.S. recession will be more akin to those of the 1970s and early 1980s. Those "retro" recessions were caused by the Fed's decision to raise rates aggressively in response to rising inflation. The good news is that it will take a while for inflation to accelerate, suggesting that the next recession will not occur until 2019 at the earliest. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Remain overweight global equities for now, favoring European and Japanese stocks over U.S. equities in currency-hedged terms. Look to reduce exposure in the second half of next year. Feature After Charlottesville Political developments continued to cast a pall over markets this week. Last week's worries about escalating tensions in the Korean peninsula subsided on comments from the North Korean regime that it would not launch a preemptive strike against Guam. As that issue moved off the radar screen, a new one emerged. President Trump's comments about the violent protests in Charlottesville generated outrage in many quarters, leading to the disbandment of two of the President's business advisory councils. We agree with those who argue that this latest incident will have far-reaching consequences. However, we disagree about the timeframe over which they will manifest themselves. As with most Trump scandals, this one is likely to fizzle into the background. Republicans in Congress would love nothing more than to change the subject. Plowing ahead with tax cuts is one way to do that. A limited infrastructure bill also remains a possibility - and unlike most issues up for debate, this one could actually attract bipartisan support. The market has essentially priced out any meaningful progress on either taxes or infrastructure, so the bar for success here is fairly low (Chart 1). While the implications of recent events in the U.S. are unlikely to put much strain on markets over the next year or so, the longer-term ramifications could be profound. The Democrats' "Better Deal" agenda moves the party to the left on most economic issues. Historically, the Republicans have been champions of small government. Increasingly, however, many Trump voters are asking themselves why exactly they should support lower business taxes when most companies seem openly hostile to the populist agenda that got Trump elected. In this respect, it is noteworthy that support for free trade among Republican voters has collapsed over the past 10 years (Chart 2). Wall Street, Silicon Valley, and the rest of the business establishment tends to be liberal on social issues and conservative on economic ones. The problem is that very few voters share this configuration of views (Chart 3). This contradiction cannot be ignored indefinitely. Chart 1The Markets Have Given Up On Infrastructure And Taxes Chart 2Republican Support For Free Trade Has Collapsed Chart 3An Absence Of Libertarians We predicted that "The Trumpists Will Win" back in September 2015 when most pundits were still scoffing at the idea that Trump could win the Republican nomination, let alone the election. This prediction was based on the view that "Trumpism" would resonate with American voters more forcefully than most experts thought possible. If the Republican Party does move to the left on economic issues, this could lead to more economic instability and larger budget deficits - and ultimately, much higher inflation. We discussed the reasons why inflation is heading higher over the long haul several weeks ago and encourage readers to review that report.1 Still Chugging Along Over a shorter-term horizon of one or two years, however, things still look reasonably bright. Earnings are in a solid uptrend. The profit recovery has been broad-based across countries and sectors. Our global leading economic indicator is trending higher, as are estimates of global growth (Chart 4). Chart 4Global Growth Estimates Accelerating Despite Stalled U.S. Growth The current economic recovery in the U.S. has now lasted over eight years, making it the third-longest on record. If it continues until July 2019, it will take the top spot from the 1990s expansion. The fact that this expansion has endured for so long is not too surprising. The Great Recession was one of the deepest in history, while the recovery that followed has been fairly drawn out. Such "slow burn" recoveries are typical following financial crises, and this one has not been any different. However, now that the U.S. unemployment rate has returned to pre-recession levels, the question arises whether the curtain may finally be closing on this expansion. Our answer is "not yet." While this expansion is starting to get long in the tooth, the next recession probably won't roll around until 2019 - and perhaps even later. This means that a cyclically bullish stance towards risk assets is still appropriate. Searching For The Smoking Gun As the old saying goes, "Expansions don't die of old age. They are murdered by the Fed." Such a verdict is too harsh, but it does get to an underlying truth: Fed rate hikes have almost always preceded past U.S. recessions (Chart 5). Broadly speaking, post-war recessions can be broken down into two categories. The first consists of recessions that resulted from the bursting of asset bubbles. In those cases, Fed rate hikes were more the instigator of the recession than the cause of it. The second category consists of recessions where the Fed found itself behind the curve in normalizing monetary policy and was forced to raise rates aggressively in response to rising inflation. The last three recessions were all of the first variety. The 1990-91 recession stemmed from the commercial real estate bust and the ensuing Savings and Loan crisis. The 2001 recession was caused by the bursting of the dotcom bubble. And, of course, the Great Recession was largely the product of the housing bust and weak mortgage underwriting standards. Today's financial landscape is far from pristine. Corporate debt is close to record high levels as a share of GDP and asset valuations are stretched across the board (Chart 6). However, while these imbalances are bad enough to exacerbate a recession, they do not appear severe enough to cause one. This suggests that the next downturn may look less like the last three recessions and more like the "classic" or "retro" recessions of the 1960s, 70s, and early 80s. Chart 5Who Kills Economic Expansions? Chart 6Debt Is Rising, As Are Asset Values Inflation Remains Benign ... For Now If we are heading for a retro recession, investors should keep a close eye on inflation. This is simply because the Fed is unlikely to turn very hawkish until inflation starts accelerating. The good news is that inflation should remain dormant for at least the next 12 months. In fact, most measures of consumer price inflation have decelerated since the start of the year (Chart 7). Producer prices also fell unexpectedly in July, the first outright decline in 11 months. The St. Louis Fed's Price Pressures index remains near rock-bottom levels (Chart 8). Chart 7Consumer Inflation Has Decelerated Of Late Chart 8Price Pressures Are Muted... For Now Inflation expectations are still reasonably well anchored and trade unions have less clout than they once did. Shale producers also have the ability to ramp up production in response to higher oil prices. Past episodes of rapidly rising inflation were often accompanied by supply disruptions that led to spiraling energy costs. Moreover, at least for the time being, higher imports can absorb some of the excess in U.S. aggregate demand. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Inflation is a highly lagging indicator. As we have noted before, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 9). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 9Inflation Is A Lagging Indicator Timing Matters Too Doesn't a very low neutral real rate reduce the risk that the Fed will find itself behind the curve? The answer is "yes," but only to a limited extent. Suppose, for the sake of argument, that the Fed knew the exact level of the neutral real rate. It would still be the case that a major delay in bringing interest rates up to that magic number would cause the unemployment rate to fall below NAIRU, leading to an overheated economy. Such an economy may not generate inflation immediately, but both history and simple logic suggest that a situation where aggregate demand continues to outstrip supply will eventually produce upward pressure on prices. The lesson here is that successful monetary policy does not just require that central banks bring rates to the correct level. They also have to bring rates to the correct level at the right time. That is difficult to do, which is why soft landings following monetary tightening cycles are few and far between. Fed Dots Too Optimistic About Labor Force Growth And Productivity The Fed "dots" foresee the unemployment rate ending the year at the current level of 4.3% and falling marginally to 4.2% in 2018. The Fed also expects real GDP to grow by 2.2% in Q4 of 2017 and 2.1% in Q4 of 2018 over the previous year. This is similar to the average rate of GDP growth since the start of the recovery, a period where the unemployment rate fell by over five percentage points. Thus, the only way the Fed's math can add up is if labor force growth accelerates or productivity growth increases. Neither outcome is likely. The labor force participation rate has been flat for the past four years, despite the fact that an aging population has pushed more people into retirement. Chart 10 shows that the participation rate has fallen by three percentage points since 2008, only 0.3 points less than one would expect based solely on changes in the age distribution of the population. Much of the remaining gap can be explained by the secular decline in participation rates within young-to-middle age cohorts, offset in part by higher participation among the elderly (Chart 11). In particular, the downward trend in participation among less-educated workers appears to be more structural than cyclical in nature (Chart 12). As we noted last week, the growing shortage of workers is already visible in employer surveys and rising wage pressures at the lower end of the skill distribution.2 Thus, far from accelerating, chances are that labor force growth will decelerate as the economy runs out of people who can be persuaded to seek out gainful employment. This could cause the unemployment rate to fall further than the Fed expects. Chart 10Demographic Shifts Explain Most Of The Decline In Participation Rates Chart 11Participation Rates Across Age Cohorts Chart 12Labor Force Participation Has Fallen ##br##The Most Among The Less-Educated Productivity is also unlikely to make a significant rebound. The drop in productivity growth has been broad-based across industries and countries. Moreover, it began several years before the financial crisis, suggesting that the Great Recession was not the main culprit. All this points to underlying structural factors - such as a weaker pace of innovation and flagging educational achievement - as being the key drivers of the productivity slowdown.3 What Goes Down Must Come Up If labor force growth fails to accelerate and productivity growth remains weak, then the current pace of GDP growth of around 2% will push the unemployment rate down from current levels. Needless to say, if GDP growth accelerates above 2%, unemployment will drop even more. Such an outcome is, in fact, quite likely given the significant easing in financial conditions that the U.S. has experienced over the past few months. All this means that the unemployment rate may be on its way to falling below its 2000 low of 3.8% by next summer. This would leave it close to a full percentage point below the Fed's estimate of NAIRU. At that point, the unemployment rate would have nowhere to go but up. And, unfortunately, history suggests that once unemployment starts rising, it keeps rising. In fact, the U.S. has never averted a recession in the post-war era when the three-month average of the unemployment rate has risen by more than one-third of a percentage point (Chart 13). Chart 13Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The Not-So-Prescient Stock Market If the U.S. does succumb to a recession in 2019 or 2020 because the Fed is forced to hike rates aggressively in response to rising inflation, how quickly will the market sniff out an impending downturn? Chart 14 plots the value of the S&P 500 around the time of past recessions. On average, the stock market has peaked six months before the beginning of a recession. However, there is quite a bit of variation from one episode to the next (Table 1). The S&P 500 peaked only two months before both the Great Recession and the 1990-91 recession. It peaked seven months before the 2001 recession, but that downturn was arguably more the product of the stock market bust than the cause of it. Chart 14Profile Of U.S. Stocks Around Recessions Table 1Stocks And Recession: Case By Case On the whole, the stock market is not particularly good at anticipating recessions triggered by financial sector imbalances. The stock market is more adept at predicting downturns caused by excessively tight monetary policy - although even here, it is difficult to know how much of the weakness in equities leading up to such recessions was due to rising expectations of a downturn and how much was simply the result of higher interest rates. From this, we conclude that the stock market will likely peak a few months before the next recession. If we are correct about the timing of our recession call, this implies the cyclical bull market has another 12-to-18 months left. Cyclical Leading Indicators Still Benign The bond market has generally done a better job of anticipating economic downturns than the stock market. This is especially the case for the yield curve, which has inverted in the lead-up to every single recession over the past 50 years, with only one false positive (Chart 15). While the 10-year/3-month spread has compressed over the past few years, it is still above the level that has warned of recessions in the past. Most other forward-looking cyclical indicators continue to point to an economic expansion that has further room to run. The Conference Board's Leading Economic Indicator (LEI) has consistently fallen into negative territory on a year-over-year basis leading up to past recessions (Chart 16). The LEI has accelerated since last summer, suggesting little risk of a near-term downturn. Chart 15The Yield Curve Has Called 8 Of The Last 7 Recessions Chart 16LEI Also Good At Signaling Recessions A decline in the ISM new orders component in relation to the inventory component has warned that final demand is softening while the stock of unsold goods is piling up (Chart 17). The current gap stands at 10.4, consistent with a robust expansion. Likewise, initial unemployment claims have usually risen going into past recessions (Chart 18). Neither the current level of claims nor hiring intention surveys are signaling trouble ahead. Chart 17Economic Momentum Is Still Positive Based On The ISM Chart 18Initial Claims Claim Everything Is Okay Changes in financial conditions tend to lead GDP growth by around 6-to-12 months. Thus, it is not surprising that recessions have often occurred in the wake of a tightening in financial conditions (Chart 19). As noted above, U.S. financial conditions have eased sharply since the start of the year. Chart 19Recessions Tend To Occur When Financial Conditions Are Tightening Investment Conclusions Historically, recessions and equity bear markets have gone hand in hand. As my colleague Doug Peta likes to emphasize, it simply does not pay to be underweight stocks unless one has legitimate reasons for thinking that another economic downturn is just around the corner (Chart 20).4 Our analysis suggests that another recession is still at least 18 months away. This is confirmed by a variety of recession-timing models, all of which are signaling low risks of an impending downturn in growth (Chart 21). As we noted last week, wage growth is likely to accelerate over the next few quarters. This will prop up consumer spending. July's blockbuster retail sales report was no fluke - there are plenty more where it came from. Stronger U.S. growth will force the market to revise up the miserly 41 basis points in rate hikes that it has priced in over the next two years. This will push up Treasury yields and give the dollar a boost. The greenback has usually strengthened whenever an overheated labor market has caused labor's share of income to rise (Chart 22). We expect the broad trade-weighted dollar to appreciate by about 10% over the next 18 months. Chart 2050 Years Of Recessions And Bear Markets Chart 21No Imminent Risk Of A Recession Chart 22Historically, A Rising Labor Share Has Pushed Up The Dollar A stronger dollar is necessary for tilting U.S. consumption towards foreign-made goods, thereby allowing domestic spending to rise in the face of tighter supply constraints. This is good news for foreign producers in developed economies, but could cause trouble for firms in emerging markets which have taken out large amounts of dollar-denominated debt. We continue to prefer European and Japanese stocks over their U.S. counterparts in currency-hedged terms. In the EM space, Chinese H-shares are our preferred market. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. 2 Please see Global Investment Strategy Weekly Report, "What's The Matter With Wages?," dated August 11, 2017. 3 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 4 Please see Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. 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-8 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 Geopolitical tensions will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a major military conflict or escalating trade wars with significant economic damages, the impact on both the broader growth outlook and financial markets should be limited. President Trump's recent decision to probe China's IPR practices is his first direct trade measure against China, and therefore is of important symbolic significance, but the near term impact should be limited. There is enough common ground for the two sides to avoid direct confrontation. We expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Short KRW/JPY as a hedge against geopolitical risk in The Korean Peninsula. There is an economic case for the trade, even without geopolitical considerations. Feature The Chinese economy is experiencing a summer lull, as most recent growth figures have disappointed, albeit slightly. Exports, production, investment and retail sales have all decelerated, underscoring that growth momentum is softening across the board. Investors have largely shrugged off the weaker-than-expected numbers, a sign that the market is not overly concerned about a major relapse down the road. We share investors' optimism, as discussed in some recent reports,1 but are watchful for signs of market complacency.2 After the most recent rally, multiples of Chinese equities are no longer exceptionally cheap by historical norms, even though they are still a lot cheaper compared with most other major global and EM bourses. We will discuss Chinese equity valuations in greater detail in the coming weeks. Geopolitical risks have dominated Greater China markets of late. The escalation of tensions surrounding North Korea briefly took their toll in the past week. On Monday, U.S. President Donald Trump authorized U.S. Trade Representative Robert Lighthizer to determine whether to launch an investigation into China's alleged theft of intellectual property. Overall, both events underscore rising geopolitical tensions globally, particularly around China. So long as the situation does not degenerate into a major military conflict or an escalating trade war that causes major economic damage, the tensions should not have a material impact on the outlook for the Chinese and global economy, as well as financial markets. A short position on the Korean won versus the Japanese yen offers a low-risk hedge against a sudden escalation of geopolitical tensions in the region. Intellectual Property Investigation: The Knowns And Unknowns It is unclear at the moment whether Trump is simply using the investigation as a bargaining chip to seek concessions/cooperation from China, or to start a trade war with lose-lose outcomes. The situation needs to be closely monitored and assessed continuously. For now, a few observations are in order: This is the first direct trade measure by the Trump administration against China, and therefore is of important symbolic significance, but the near-term impact should be limited. President Trump has only authorized his administration to determine whether or not to formally investigate Chinese policies and practices. It may take a year to finalize the decision, and even longer to begin negotiations and discussions with Chinese officials for solutions and remedies. Previous similar investigations against Chinese products resulted in bilateral agreements rather than all-out confrontations. Trump's decision is based on Section 301 of the Trade Act of 1974, which allows the president to unilaterally impose tariffs or other trade restrictions to protect U.S. industries from "unfair trade practices" of foreign countries. This was a popular trade tool in the 1980s and was used to impose tariffs against certain Japanese and Korean products, but has been rarely used in the past decade. In 2010 the Obama administration also accepted a petition under Section 301 to investigate China's state support for clean-energy exports, particularly solar panels and wind turbines, and the Chinese government later promised to limit some of these practices through bilateral negotiations. The World Trade Organization (WTO) has ruled that taking any such actions against other member countries without first securing approval under WTO rules is, in of itself, a violation of the WTO Agreement, and can be challenged under the WTO framework. In fact, section 301 investigations have not resulted in any trade sanctions since the WTO was set up in 1995. Table 1Top Challenges Doing Business In China More importantly, we see common ground enabling the U.S. and China to work together to improve China's Intellectual Property Rights, or IPR practices. From the U.S.'s perspective, while Trump's blunt accusations on China's trade policies are not completely justified and will not solve the massive trade imbalances between the two countries, his challenge on China's IPR infringement has legitimate ground, and resonates well within the broader American business community. American companies doing business in China have long listed intellectual property rights infringement and protectionism as top challenges, especially among industrial and resources businesses (Table 1). In other words, Trump's complaints on China's IPR practices reflects corporate America's rational voice rather than a sensational rant. China's own practices are also in conflict with its intentions to build a more open and market-friendly policy environment. Indeed, China has also been making notable progress to enhance IPR protections. In September 2015, in his state visit to the U.S., President Xi promised to limit the scope of national security reviews on investment, refrain from cyber-enabled IP theft, and uphold WTO agreements regarding market access for information and communications technology (ICT) products. China's deficits in IP royalty fees has increased sharply in recent years, while America's royalties surpluses have been expanding (Chart 1). Furthermore, 90% of American firms doing business in China believe that China's IPR enforcement has improved over the last five years, according to American Chamber Of Commerce In China (AmCham China) surveys.3 In short, there is certainly room for further improvement in China's IPR practices, and the broad direction fits with Trump's expectations, creating common ground for the two sides to avoid direct confrontation. We expect China's IPR practices will continue to converge towards international standards going forward. Chart 2 shows Chinese patent applications have exploded in recent years. As the country's technology continues to advance and local businesses are growing more aware of the value of intellectual property, China will develop a keen interest to safeguard its own IPRs. We are hopeful that Trump's investigation will provide a catalyst for further improvement in Chinese IPR practices, rather than derail broader bilateral trade. Chart 1China's Widening Deficits In IPR Royalty Chart 2China's Exploding Patent Applications ##br##Will Demand Stricter IPR Protections North Korea Tensions, And Short KRW/JPY As A Crisis Hedge The escalation of geopolitical tensions surrounding North Korea briefly took a toll on global and Greater China markets in the past week. The situation remains highly fluid, and the stakes are exceedingly high - both of which will put investors on edge in the weeks and months ahead. Our Geopolitical team in their latest assessment concludes that the U.S. is not likely to preemptively attack North Korea. However, the U.S. has an interest in signaling that it may conduct precisely such an attack, and brinkmanship could last for a long time.4 As far as China is concerned, there is genuine interest among the Chinese leadership to de-escalate tensions on the Korean Peninsula, but there is no easy solution. On one hand, it is absolutely against the country's best interests to collapse the North Korea regime. Such an outcome could see a surge of refugees to its densely populated and economically struggling Northeast region. Moreover, it could also potentially lead to a strong and unified Korea at the Chinese border that is a military ally to the United States. On the other hand, Beijing also feels that it has fallen victim to North Korea's nuclear ambitions, and has become growingly frustrated by its escalating provocations. China also fears that North Korea's nuclear program could encourage countries in the region, particularly Japan, to develop their own nuclear arsenals, which would be viewed as strategically threatening to China's national security. For now, we expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Already, China has supported the United Nations Security Council in imposing new sanctions on North Korea last week. Early this week, the Commerce Ministry announced a ban on imports of iron ore, iron, lead and coal from North Korea. These actions may have contributed to the softened tones from North Korea since, but it remains to be seen whether the impact will be long-lasting. The upshot is that the shared interests between China and the U.S. on various major global issues mean that the risk of an escalating trade war between the two countries should remain under control. For investors, bouts of geopolitical tension will likely bid up traditional safe-haven assets such as gold and the Swiss franc going forward. Another way to play the geopolitical risk is to short the Korean won (KRW) and long the Japanese yen (JPY). The KRW will obviously suffer devastating losses in even mild military skirmishes between the U.S. and North Korea, while the JPY may benefit from any "risk-off" unwinding of the yen carry trade. More importantly, economic fundamentals are not supportive of a stronger KRW, especially against the JPY, which means the downside risk in shorting the KRW/JPY is quite low, even without geopolitical considerations. Chart 3The Won Is Expensive Against The Yen The KRW is expensive against the JPY, based on a purchasing power parity (PPP) assessment (Chart 3). The 30% rally of KRW/JPY since 2012 has pushed it to an over two-sigma overshoot above its PPP fair value. Historically the won has rarely been sustainable at such elevated levels. Korea's economic outlook remains uninspiring. Capacity utilization has continued to decline, pricing power is weak, money growth is decelerating and real retail sales growth has stalled (Chart 4). Exports have been the bright spot in the overall growth picture, recovering strongly from last year's slump, but it is unrealistic to expect the export sector to continue to accelerate if growth numbers in China downshift. Softening exports will further weigh on Korea's growth outlook. In contrast, the latest growth numbers confirm that the Japanese economy has improved notably (Chart 5). Real GDP expanded by 1% in the second quarter compared with the previous three months, significantly beating expectations. While it remains to be seen whether Japan is able to maintain its regained momentum going forward, its growth gap with Korea has narrowed considerably of late, which will also lend support to the yen against its Korean counterpart. Chart 4Korea Growth Is Set To Moderate Chart 5Japan And Korea: Growth Gap Has Narrowed The bottom line is that geopolitical tensions in the Korean Peninsula will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a significant military conflict that causes major economic damage, the geopolitical skirmishes should not have a material impact on both the broader growth outlook and financial markets. Investors may consider shorting the KRW/JPY as a hedge for geopolitical risks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, and "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. 3 AmCham In China 2016 White Paper 4 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS Chart I-5BEM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Chart I-6BAsian Manufacturing Production Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Chart 2The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher Chart 5Supports For Global Growth In Place Chart 6Global Economic Activity Brightening Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.