Fixed Income
Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
The outlook for Treasury yields has certainly evolved alongside the major macro moves that have gripped markets in 2018. At the beginning of the year, many strategists were throwing around big numbers like 4% for 10-year yields as conditions seemed like they…
Highlights Duration: The Fed is unlikely to slow its 25 bps per quarter rate hike pace until there is sufficient evidence pointing to a slow-down in economic growth. Maintain below-benchmark duration in U.S. bond portfolios. Yield Curve: The yield curve will remain near its current level and await confirmation from rising wage growth. The 2-year maturity point is becoming more attractive, and it will soon be time to switch our yield curve positioning from favoring the 5-year/7-year part of the curve to the 2-year. Economy: The global growth data improved somewhat during the past month, but weak foreign growth remains the greatest risk to the U.S. recovery and the Fed's 25 bps per quarter rate hike cycle. Feature Treasury yields increased last week. The 10-year is once again flirting with 3% and the market now discounts four 25 basis point rate hikes by the end of 2019. This time last week it was only priced for three (Chart 1). Chart 110-Year Testing 3% Last week's bearish price action occurred despite core inflation and retail sales both printing well below expectations. But the market saw through the economic data and instead took its cue from a speech given by Fed Governor Lael Brainard.1 A speech that was rightly interpreted as hawkish. We view last week's speech as important because Governor Brainard effectively refuted two arguments that the Fed could use to justify a slower pace for rate hikes in the coming months. Brainard's message to markets is that if any investor still expects the Fed to rely on one of those excuses, they should think again. Getting Close To Neutral One potential reason for the Fed to slow its 25 bps per quarter rate hike pace is that current FOMC estimates place the longer-run neutral fed funds rate between 2.8% and 3.5%.2 This means that four more rate hikes would be sufficient for monetary policy to move from accommodative to neutral. If those neutral rate estimates turn out to be correct, then the Fed might be justified in halting its rate hike cycle this time next year. The problem, as we have pointed out in several prior reports, is that the error bars around such neutral rate estimates are very wide. So wide that we think the FOMC will pay them little attention and focus instead on trends in the actual economy and financial markets.3 Governor Brainard attacks the issue from a different angle, but arrives at the same conclusion. Brainard's framework draws a distinction between the short-run neutral rate - which is allowed to fluctuate in response to changes in the economy - and the long-run neutral rate - which is the neutral rate that prevails "after transitory forces reflecting headwinds or tailwinds have played out." In practice, this distinction means that if the economy proves resilient to a rising fed funds rate, we should conclude that the short-run neutral rate is moving higher. This would mean that higher interest rates are required before monetary policy turns restrictive. If economic tailwinds are strong enough, the short-run neutral rate could even move above the long-run rate. This framework leads to the same investment strategy we have suggested in many prior reports. Investors should ignore neutral rate estimates altogether, and focus instead on monitoring the economy and financial markets for signals that monetary policy is turning restrictive. Some potential signals we have suggested in the past include:4 When year-over-year nominal GDP growth is below the fed funds rate When cyclical spending slows as a percentage of overall GDP When the Treasury curve inverts When the gold price breaks dramatically lower Governor Brainard's speech pointed to one more indicator that we should add to our list: evidence of tightening from indicators of overall financial conditions. The strong relationship between financial conditions and future economic growth is well documented, meaning that Fed rate hikes will only exert a drag on growth if they translate into tighter overall financial conditions. Charts 2, 3 and 4 show how this played out during the past three Fed tightening cycles. Chart 2 shows that financial conditions tightened immediately after the Fed first raised rates in March 1997. They continued to tighten until the Fed stopped hiking in mid-2000. In contrast, Chart 3 shows that financial conditions did not tighten immediately when the Fed first lifted rates in June 2004, but that they eventually tightened as the Fed persisted with hikes. Chart 4 shows how financial conditions have evolved in the current cycle. Broadly speaking, overall financial conditions appear easier now than when the rate hike cycle began in December 2015. In other words, Fed rate hikes have so far not translated into tighter financial conditions. In Brainard's framework this can only mean that the short-run neutral rate has been rising alongside the fed funds rate. This suggests that more rate hikes are required to tighten overall financial conditions and slow growth. Chart 2Financial Conditions: 1990s Chart 3Financial Conditions: 2000s Chart 4Financial Conditions: Present Day Inflation Is Well Contained A second reason why many have suggested that the Fed could slow its pace of rate hikes is that inflation remains well contained near the Fed's target, and the risk of a meaningful overshoot appears low. At 2.19%, year-over-year core CPI inflation is consistent with the Fed's target. However, our Base Effects Indicator suggests it will decelerate during the next six months (Chart 5). Our core PCE Base Effects Indicator sends a similar message, as we showed in a recent report.5 But Brainard suggested that the Fed should broaden its scope beyond a simple inflation target. Specifically, she observed that: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve's assessment suggests that financial vulnerabilities are building[.] As evidence that financial vulnerabilities are rising, Brainard pointed to low corporate bond spreads, rising corporate debt levels and easing underwriting standards (Chart 6). This would appear to make the case for further rate hikes even if inflation remains well contained near the Fed's target. Chart 5Inflation Will Stay Close To Target Chart 6Brainard Looks Beyond Inflation Bottom Line: The Fed is unlikely to slow its 25 bps per quarter rate hike pace until there is sufficient evidence pointing to a slow-down in economic growth. Maintain below-benchmark duration in U.S. bond portfolios. Treasury Curve: Considering The 2-Year As we pointed out last week, the Treasury curve has already discounted a significant acceleration in wage growth (Chart 7).6 This is fairly common cyclical behavior. In each of the past two cycles the Treasury curve has flattened sharply and then leveled-off at a low level as wages accelerated. We expect we have now reached this latter stage. The 2/10 slope will stay near its current level for a time, awaiting confirmation from wage growth. Chart 7Waiting For Wages In our view, the more interesting yield curve trend is that the spread between the 2-year yield and the fed funds rate has widened to above the 2/10 slope (Chart 7, panel 2). Periods where the fed funds/2-year slope exceeds the 2-year/10-year slope are rare, and tend to be quickly followed by fed funds/2-year flattening. The attractiveness of the 2-year note is confirmed by our butterfly spread models. We model different butterfly spread (bullet over duration-matched barbell) combinations relative to the slope between the two legs of the barbell.7 Our models show that the 2-year bullet is consistently cheap relative to different barbell combinations, and in fact cheaper than all other bullet maturities (Table 1). Table 1Butterfly Strategy Valuation At present, we recommend a yield curve position that is long the 7-year bullet and short the 1/20 barbell. We will continue to hold this position for the time being because, while the 2-year note appears cheaper than the 7-year, we think the 2-year has room to cheapen even further. As mentioned at the beginning of this report, the Treasury market is priced for just barely four rate hikes between now and the end of 2019. The 2-year yield has further upside as more rate hikes get priced in. The upside in the 7-year yield is more limited. Bottom Line: The yield curve will remain near its current level and await confirmation from rising wage growth. The 2-year maturity point is becoming more attractive, and it will soon be time to switch our yield curve positioning from favoring the 5-year/7-year part of the curve to the 2-year. Global Growth Update Governor Brainard's speech shot down two arguments for why the Fed might turn more dovish, but this certainly does not rule out the Fed slowing its pace of rate hikes if economic growth starts to weaken. In past reports we noted that the Global Leading Economic Indicator (LEI) excluding the U.S. is below zero (Chart 8). Since 1993, every time the Global ex. U.S. LEI has fallen below zero, the U.S. LEI has eventually followed. It is conceivable, and perhaps even likely, that the same dynamic will play out again. However, the most recent data on global growth have been somewhat more optimistic. While the Global Manufacturing PMI (excluding the U.S.) has been trending lower, it remains at healthy levels compared to recent history (Chart 8, panel 2). Further, our Global PMI Diffusion index perked up in August, and now shows that 86% of the 36 countries in our sample have PMIs above the 50 boom/bust line (Chart 8, panel 3). The Global LEI also ticked higher in July, and its diffusion index increased, though it remains below 50% (Chart 8, bottom panel). While the monthly LEI and PMI data have improved, indicators of investor sentiment derived from both surveys and financial market prices remain downtrodden. The Global ZEW survey of investor sentiment, the performance of cyclical equity sectors versus defensives and our Boom/Bust Indicator all suggest that U.S. bond yields are too high for the global growth environment (Chart 9). Chart 8Slight Improvement In Global Growth Chart 9High Frequency Global Growth Indicators It's difficult to say how this will all play out, but our sense is that there remains a strong chance that weak foreign growth will eventually drag the U.S. lower. This will cause the Fed to pause its rate hike cycle for a time. However, given the uncertainty surrounding this outcome and the fact that the market is already priced for only two rate hikes in the remainder of 2018 and two more in all of 2019, we view the balance of risks as still consistent with below-benchmark portfolio duration. Bottom Line: The global growth data improved somewhat during the past month, but weak foreign growth remains the greatest risk to the U.S. recovery and the Fed's 25 bps per quarter rate hike cycle. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 2 Governor Brainard defines the neutral fed funds rate as: "the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation." 3 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights When projecting the future course of interest rates, the Fed is the best place to start: Although the Fed only expressly controls short rates, its influence is felt across all maturities. Until it inverts the yield curve, its rate-hike campaigns push all yields higher. Its decisions are influenced by inflation, ... : Our checklist of items that might lead us to change our below-benchmark duration view includes key consumer price series as well as inflation expectations and estimates of the economy's supply-demand balance. ... the state of the labor market, ... : We are monitoring compensation trends and ancillary employment measures in addition to the headline unemployment rate to get a fix on how much slack remains in the labor market. ... and signs of major imbalances: Heading off, or ameliorating, a crisis is the third element of the Fed's mandate. Major economic or financial imbalances, or an overseas crisis, could alter the Fed's policy course, and we are on the lookout for them. Feature Over the last seven weeks, we have laid out our big-picture views on markets and the economic backdrop influencing them. We see rates going higher (July 30th Weekly Report); credit performance deteriorating, albeit slowly (August 6th Weekly Report); and the equity bull market stretching into the second half of next year (August 13th Special Report). We do not foresee a recession before 2020 (August 13th Special Report), in large part because we do not expect the monetary policy cycle to turn until the second half of next year (September 3rd Special Report). With that cyclical framework in place, we can now turn to an analysis of the relevant real-time data and its impact on our market outlooks. Checklists are useful tools to help systematize that analysis. They also help track the evolution of our views in real time. Consistent tracking helps us evaluate and improve our process, while making it easier for clients to think along with us, and anticipate our next moves. This week, we introduce our rates checklist, which details the key series we're watching that could encourage us to change our below-benchmark duration recommendation. We will roll out a companion equity checklist next month. The Fed Versus Market Expectations Table 1Rates View Checklist Our aversion to Treasuries largely stems from our view that the Fed will hike more than markets currently expect. The divergence between our view and the markets' view can be resolved in one of two ways: the market can revise its rate-hike expectations higher to meet ours, or we can lower our expectations to meet theirs. Long-maturity bonds will sell off in the former scenario, validating our below-benchmark-duration call, but the call will underperform if we have to cut our expectations. The "Market Perceptions of the Fed" section of our checklist (Table 1) is designed to highlight changes in the Fed's actions or investors' interpretation of them. Opportunities to earn market-beating returns arise from divergences between outcomes and consensus expectations. If, as we expect, the fed funds rate peaks at 3.5% or above in this cycle, well ahead of the current 3% market expectation, below-benchmark-duration positions will outperform. As the consensus expectation approaches our expectation, however, the incremental return from estimating the terminal rate more accurately than the consensus shrinks. The first checklist item monitors the difference between our terminal rate projection and the market projection as implied by overnight index swaps. As the distance narrows between our estimate (marked by the "X"s in Chart 1), and the peak of the OIS series, so too will the prospective rewards from below-benchmark-duration positioning. The checklist also tracks the yield curve for its insight into whether or not rate hikes have gone too far (Chart 2).1 One explanation for inversion in the latter stages of tightening cycles holds that the curve inverts once the bond market senses that monetary conditions are sufficiently tight to induce a material slowdown. As much insight into future growth prospects as the orientation of the yield curve might offer, however, neither it nor any of the other checklist items acts as a standalone indicator. Even if the curve were to invert tomorrow, we would not change our view without corroboration from several other factors. Chart 1The Consensus Is Way Behind The Curve Chart 2Still Plenty Of Margin For Error Inflation And Its Drivers Price stability is one half of the Fed's statutory mandate, enshrining inflation as a critical policy driver. In our base-case scenario, adding significant fiscal stimulus to an economy already operating at its full potential will consume what remains of spare capacity, fueling upward inflation pressures. The policy upshot is that the Fed will be unable to stop hiking rates until it gains some control over inflation. Since tightening monetary conditions enough to throttle inflation is likely to induce a recession, we expect that rates will rise before they ultimately fall. To track the course of inflation, and the accuracy of our projections, we are looking at headline and core CPI, and headline and core PCE (Chart 3). We will also monitor estimates of the output gap to gauge the potential for inflation pressures to turn into accelerating inflation (Chart 4). We are keeping a close eye on inflation break-evens, the expected level of inflation implied by the difference in yields on nominal and inflation-protected Treasuries. Our bond strategists peg 2.3-2.5% as the break-even level consistent with the Fed's 2% inflation target, and expect that the Fed will turn more hawkish once break-evens threaten the top end of the range (Chart 5). Failure to make progress toward that level in a timely fashion would force us to take a hard look at our stance. Chart 3Inflation Is Slowly Creeping Higher Chart 4If The Output Gap Really Is Closed, ... Chart 5... Inflation Will Normalize The State Of The Labor Market The relative tightness of the labor market is an important determinant of the level of slack in the overall economy. Phillips Curve adherents (along with anyone else who believes in the law of supply and demand) also view labor market slack, or the lack thereof, as a key variable in wage growth and a meaningful influence on the overall level of inflation. We are watching the headline unemployment rate relative to estimates of NAIRU,2 the minimum level of unemployment the economy can sustain without overheating. If unemployment remains below NAIRU, the Fed will have little choice than to remain vigilant; if it rises, or estimates of NAIRU are revised lower, the Fed may be able to ease up a little (Chart 6). Chart 6Sub-NAIRU Unemployment, ... We are also looking at ancillary indicators of labor market health like the broader U-6 measure of unemployment3 (Chart 7, top panel); the participation rate of work-age citizens in the labor market (Chart 7, second panel); and the quit rate, which sheds light on how easily workers can switch jobs (Chart 7, bottom panel). The first two measures offer insight into the potential size of the pool of workers available to re-enter the labor market and relieve supply constraints, while the last focuses on employee bargaining power, which should impact wages. We also look at a range of compensation growth measures: the average hourly earnings series from the monthly employment situation report (Chart 8, top panel); the Atlanta Fed wage tracker, which follows the same employees from year to year, sidestepping the composition issues that broader surveys face (Chart 8, second panel); and the employment cost index (including benefits), our choice for the single best compensation measure (Chart 8, bottom panel). Chart 7... And Declining Chart 8... Argue For Higher Wages The Fed's Third Mandate In addition to maintaining price stability and full employment, the Fed also has to protect the economy from shocks or at least try to mitigate their impact. Previous Feds may not have had much taste for supervisory matters, but supervision is now an explicit point of emphasis. There do not appear to be lending excesses today, and Basel III and Dodd-Frank would seem to make them much less likely than they were before the crisis. Corporations have made the most of a parade of indulgent bond buyers, securing promiscuously easy covenants, but turmoil in the bond market does not necessarily pose a systemic threat. In our view, excesses in this cycle are more likely to emerge from typical economic overheating. We are monitoring the most cyclical economic segments' share of activity, though it remains well below previous peaks (Chart 9). But just last week, in a speech about the neutral policy rate, Governor Brainard suggested that an overheating economy may create financial problems instead of economic ones. Viewed in conjunction with recent speeches, the Fed seems to be building a case for tightening policy in response to frothy credit conditions. Chart 9Cyclical Engines Aren't Overheating Yet "The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve's assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates. Rising risks are notable in the corporate sector, where low spreads and loosening credit terms are mirrored by rising indebtedness among corporations that could be vulnerable to downgrades in the event of unexpected adverse developments. Leveraged lending is again on the rise; spreads on leveraged loans and the securitized products backed by those loans are low, and the Board's Senior Loan Officer Opinion Survey on Bank Lending Practices suggests that underwriting standards for leveraged loans may be declining to levels not seen since 2005."4 Central bank orthodoxy has long held that raising interest rates specifically to prick a bubble is self-defeating because it will likely provoke undesirable collateral damage. But the Fed could presumably justify hiking more than it otherwise would on the grounds that post-crisis banks are far more insulated from loan losses than they have been for several decades. Sustained by their fortified capital positions, banks wouldn't stem the flow of credit as much as they normally would in response to a pickup in provisions and charge-offs, so it would take a higher fed funds rate to slow the economy enough to counter overheating. This is a somewhat esoteric argument, to be sure, but Fed thinking appears as if it may be evolving in that direction. Our final checklist item is major international duress. An overseas crisis, or near-crisis, could pose a dual threat to our rates view. On the one hand, it could spark a flight to quality that brings Treasury yields down. On the other, it could lead the Fed to back off of tightening in the fear that international turmoil could begin to impact the U.S. economy. In our view, the odds of the current EM rumblings deterring the Fed from its "gradual-pace" roadmap are long. The U.S. economy is not only an 800-pound gorilla, it's an especially insular 800-pound gorilla. Only the most significant EM event would cause ripples within the U.S. - even the Asian Crisis failed to register in the U.S. for a year and a half after the Thai baht's collapse, and only then via a hedge fund leveraged to the gills in a way that simply is not possible today. To the extent that there is an "EM put" that could stay the Fed's hand, it's a put with a strike price that is way out of the money. Investment Implications Maintain below-benchmark Treasury duration and underweight fixed income overall. Rates are going to rise more than the consensus expects. We remain neutral on spread product within fixed income portfolios as defaults have already bottomed for the cycle, and capital losses will chip away at stingy coupons. Even though they expect the default rate will rise slowly, our fixed-income strategists are unenthused about the prospects for risk-adjusted excess returns. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 We will track the 3-month/10-year segment of the yield curve, which is less susceptible to estimate error, and has historically been more sensitive, than the widely cited 2-year/10-year segment. 2 NAIRU is an acronym for the non-accelerating inflation rate of unemployment. 3 The Bureau of Labor Statistics' U-6 series includes people working part time because they're unable to find a full-time position, and discouraged workers who are not actively looking for work and are therefore not counted as unemployed, in addition to the unemployed in the headline U-3 series. 4 Brainard, Lael (2018). "What Do We Mean by Neutral And What Role Does It Play in Monetary Policy," speech delivered at the Detroit Economic Club, Detroit, Mich., September 12. Emphasis added.
In the major developed economies, unemployment rates keep hitting new generational lows, implying that the main labor markets are tight. Yet policy interest rates remain near or at historically low levels. This raises the potential for an inflation scare. …
Highlights An inflation scare would initially take bond yields higher. But the higher bond yields would undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, an inflation scare could unleash a potentially much larger disinflationary scare. And the subsequent decline in yields would exceed the original rise. Using the 10-year T-bond yield for our roadmap (because it is least impacted by the lower bound to yields) a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Feature The global long bond yield has been trapped within a tight sideways channel for almost two years (Chart of the Week); the global equity market has also lacked any clear direction in recent quarters (Chart I-2). The result is that this year's defining feature for asset-class returns is that there is no defining feature! Global equities, bonds and cash have delivered near-identical returns.1 Chart Of The WeekThe Global Long Bond Yield ##br##Has Been Trapped Chart I-2World Equities Have Drifted ##br##Sideways This Year This is not to say that 2018 has been a dull year for investors. Far from it. But all the action has been underneath the main asset allocation decision, across sectors, regions and countries. For example, European healthcare has outperformed European banks by 35 percent; and developed market equities have outperformed emerging market equities by 15 percent (Chart I-3 and Chart I-4). Chart I-3The Main Action Has Been Across Sectors... Chart I-4...And Across Regions Unshackling Bond Yields Might Be Difficult In the major developed economies, unemployment rates keep hitting new generational lows, implying that the main labour markets are tight. Yet policy interest rates range from a crisis-level negative 0.4 percent in the euro area to just 0.75 percent in the U.K. to a modest 2 percent in the U.S. This raises the potential for an inflation scare. At any moment, the bond market might panic that central banks are well behind the (Phillips) curve.2 The spike in bond yields would of course unleash a countervailing disinflationary feedback, by cooling credit growth and credit-sensitive sectors in the economy. But this feedback would take weeks or months to take effect and to show up in the economic data. Until then, it would liberate bond yields to reach higher ground. However, there would be a more powerful and immediate feedback which would keep the shackles on bond yields. That feedback would come not from the economy, but from the financial markets themselves. In Finance 101, all investment students learn that the valuations of risk-assets depend (inversely) on bond yields. But what is less well understood is that at very low bond yields this relationship becomes exponential. Approaching the lower bound of bond yields, bonds become doubly ugly. Not only do they offer feeble returns, but the bond returns take on an unattractive asymmetry. Specifically, you can no longer make a sudden large gain, but you can still suffer a sudden deep loss. In effect, bonds become much riskier investments.3 Confronted with this increased riskiness of bonds, 'risk-assets' becomes a misnomer because risk-assets are no longer riskier than bonds! This requires risk-asset returns to collapse to the feeble return offered by bonds with no additional 'risk-premium', giving their valuations an exponential uplift (Chart I-5). The big problem is that if bond yields normalise, the process goes into sharp reverse - the lofty valuations of risk-assets must decline as exponentially as they rose. Chart I-5At Low Bond Yields ##br##The Valuation Of Equities Changes Exponentially The global bond yield appears close to this crossover point at which risk-asset valuations become vulnerable to an exponential derating. In the past year, whenever the global bond yield has reached the upper limits of its recent range - defined by the sum of 10-year yields on the U.S. T-bond, German bund, and JGB reaching 3.5 percent - the correlation between bond yields and equities has turned sharply negative (Chart I-6). And the subsequent sell-off in equities has eventually pegged back the rise in bond yields, effectively trapping them. Chart I-6At Higher Bond Yields The Correlation With Equity Prices Has Flipped From Positive To Negative But what would happen if there were an inflation scare? The answer depends on the relative sizes of the inflationary impulse compared with the disinflationary impulse that resulted from sharply lower risk-asset prices. If central banks were more concerned about the inflationary impulse, they would have to keep tightening - in which case, bond yields would be liberated to reach elevated territory. Conversely, if the bigger worry was the disinflationary impulse, central banks would quickly reverse course, and bond yields would return to the lowlands. We now explain why the disinflationary impulse from lower risk-asset prices would end up as the bigger worry. An Inflation Scare Would Be Disinflationary The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets and preceded the emerging market credit boom (Chart I-7). Chart I-7The Emerging Market Boom Happened After 2008 By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes - global equities (Chart I-8), global credit (Chart I-9), and global real estate. This makes it considerably more dangerous, because we estimate that the total value of global risk-assets is $400 trillion, equal to about five times the size of the global economy. Chart I-8Elevated Valuations On Global Equities Chart I-9Elevated Valuations On Global Credit Let's say you had an investment that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today's price must surge by 63 percent.4 If you were prudent, you might amortise today's windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. Now let's imagine a valuation derating moves the investment's returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The key takeaway is that any inflationary impulse would - through higher bond yields - undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, it could unleash a potentially much larger disinflationary impulse. A Roadmap For An Inflation Scare The high sensitivity of risk-asset valuations to bond yields is the genesis of our 'rule of 4' strategy for equity allocation, which is based on the sum of the 10-year yields on the U.S. T-bond, German bund and JGB: Above 3.5 is the level to go to a neutral exposure to equities; above 4 is the level to go underweight. Today, our metric stands at exactly 3.5 (Chart I-10). Chart I-10The 'Rule Of 4' Is At 3.5 For bonds, this means that 4 on this metric is also a good level to buy a mixed portfolio of high-quality 10-year government bonds. The equivalent level for high-quality 30-year government bonds is 5.5 (using the sum of the three 30-year yields). To sum up, an inflation scare would initially take bond yields higher. But this would threaten to unleash a much larger disinflation scare, causing the subsequent decline in yields to exceed the original rise. Using the 10-year T-bond yield as an illustration - as it is least impacted by the lower bound to yields - this would suggest the following roadmap: a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The global long bond yield is captured by the simple average of the 30-year yields on the U.S. T-bond, German bund and Japanese government bond (JGB). The global equity market is captured by the MSCI All Country World Index in local currency terms. 2 The -0.4 percent refers to the ECB deposit rate. 3 Please see the European Investment Strategy Weekly Report "The Rule Of 4 For Equities And Bonds," August 2, 2018, available at eis.bcaresearch.com. 4 5 percent compounded over ten years. Fractal Trading Model* This week’s recommended trade is an intra-commodity pair trade: short palladium/long copper. The profit target is 6% with a symmetrical stop-loss. In other trades, short euro area energy versus financials was closed at the end of its 65 trading day holding period, albeit in loss. This leaves five open trades. 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-11 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights U.S. Treasuries: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Contagion: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 2014/2015 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Feature Chart of the WeekBond Yields Following Inflation & QT, Not EM Have investors become too complacent? The selloff in emerging market (EM) assets is intensifying. The White House is threatening to slap tariffs on virtually all Chinese imports in the U.S. Accelerating wage and price inflation in the U.S. is keeping Fed rate hikes in play. The divergence between the strong U.S. economy and the rest of the world is growing wider, keeping the U.S. dollar elevated. Yet despite all that, non-EM markets show a surprising lack of concern over the EM volatility. U.S. equity indices remain close to all-time highs, while corporate bond spreads in the major developed markets are generally stable. Government bond yields remain well above levels implied by measures of economic sentiment like the global ZEW expectations index (Chart of the Week). For yields, the big issue remains, as always, the outlook for inflation and monetary policy. On that note, yields are being supported by inflation expectations, which have been boosted by faster realized inflation, tight labor markets and high oil prices. These trends are most pronounced in the U.S., where the Fed is not only hiking rates but also slowly reducing the size of its swollen balance sheet. This comes on top of the diminished pace of asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ), with the former still on track to end its net new buying of bonds at the end of the year. Against that backdrop of rising inflation and tightening global liquidity conditions, it is incorrect to solely make comparisons between today and the most recent period of EM weakness in 2014/15 that eventually spilled back violently into non-EM markets and caused the Fed to pause after only its first post-QE rate hike. The current backdrop also has similarities to the 2013 "Taper Tantrum", when the Fed surprised the markets by signaling that it was considering ending QE, triggering a spike in Treasury yields and a selloff in global risk assets. Chart 2China Remains The Key To Global Growth Then, global growth was accelerating and inflation expectations were at levels consistent with policymaker targets in the U.S. and Europe, yet central bank liquidity was slowing rapidly (mostly due to a contracting ECB balance sheet at a time when the Fed's balance sheet growth had already slowed). EM markets sold off alongside the rapid rise in U.S. Treasury yields during the Taper Tantrum. Yet with global growth accelerating and the U.S. dollar staying relatively stable, the EM selloff ended when the Fed delayed the start of the taper into 2014, providing a monetary boost to a global economy that did not need it. Today, realized inflation is even faster and central bank liquidity is again slowing rapidly. Yet market-based inflation expectations are still a bit below central bank targets, while non-U.S. growth expectations are slowing. Worries about the impact on the world economy from the brewing U.S.-China trade war are clearly weighing on the latter. The wild card will be how China responds to the tariff threat through policy stimulus. Already, China's policymakers have allowed some depreciation of the renminbi, along with some modest easing of monetary and fiscal policies, to counteract the growth threat from the Trump tariffs. BCA's China experts do not expect anything close to the massive 2015/16 package of fiscal/monetary stimulus, given the stated goal of President Xi Jinping to crack down on systemic financial risk.1 Yet the most recent figures on Chinese import growth, and higher-frequency data incorporated in the Li Keqiang index, are showing some reacceleration after the 2017 slowdown (Chart 2). At the same time, the most recent data point on the OECD's global leading economic indicator is potentially stabilizing (middle panel). A continuation of these trends could help reverse the cooling of non-U.S. growth seen so far in 2018 (bottom panel). Given all the uncertainties surrounding the U.S.-China trade battle, EM volatility and Chinese growth - at a time when global QE has turned into "QT", or "quantitative tightening", with an associated reduction in global capital flows - we continue to recommend only a neutral stance on global spread product, favoring U.S. corporates vs non-U.S. equivalents (especially avoiding EM credit). We also are maintaining our strategic recommended underweight stance on overall developed market duration, but favoring countries where monetary tightening will be more difficult to deliver (overweight U.K., Japan and Australia versus underweight U.S., euro area and Canada). A Quick Update On U.S. Treasuries: Stay Defensive Chart 3Stronger U.S. Growth = UST Underperformance The main U.S. data releases last week, the ISM surveys and the Payrolls report for August, came as a big surprise for the U.S. Treasury market. The headline ISM Manufacturing index hit a 17-year high of 61, led by increases in both the growth and inflation sub-components of the index (Chart 3), while the U.S. economy added another 200k jobs. The big shock came from the wage data in the Payrolls report, with Average Hourly Earnings rising by 0.4% in August, pushing the year-over-year growth rate to 2.9%, the highest since 2009. The Treasury market responded to data as expected, with the 10-year yield rising back to 2.94%. One of our favorite chart relationships shows the ISM Manufacturing index as a leading indicator of the momentum (12-month change) of core CPI inflation in the U.S. (Chart 4). The recent acceleration of U.S. core inflation can be explained as a lagged response to the U.S. economic growth acceleration since the start of 2016. If the relationship in this chart holds up, the current levels of the ISM are consistent with core CPI inflation accelerating to the 2.5-3% range next year. That outcome would keep the Fed on its planned rate hike path in 2019. At the moment, the market pricing of Fed rate expectations in the Overnight Index Swap (OIS) curve remains below the latest FOMC projections for the funds rate for the next two years (Chart 5). The 10-year TIPS breakeven inflation rate, which now sits at 2.1%, is still priced below the 2.3-2.5% levels that, in the past, have been consistent with inflation expectations staying well-anchored around the Fed's 2% inflation target. A combination of accelerating U.S. growth, faster wages, and a market that has not fully discounted the likely outcome for inflation and the funds rate is not a bullish one for U.S. Treasuries. We acknowledge that there could be a short-term flight-to-quality bid for Treasuries if the EM turbulence becomes more violent and finally spills over into the U.S. markets (likely through a rapid rise in the U.S. dollar). Yet without any signs of a meaningful slowing of U.S. growth or inflation, such a move would prove to be a short-lived trading opportunity rather than a true change in the rising trend for bond yields. Chart 4U.S. Inflation Acceleration Will Continue Chart 5Market Still Underpricing Fed Rate Hikes Bottom Line: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Turmoil, Then & Now, In Charts As discussed earlier, we see signs today of both of the most recent EM selloffs in 2013 and 2014/15 that were fueled by rising U.S. interest rates and a higher U.S. dollar. In the sets of charts beginning on Page 7 we present "cycle-on-cycle" analyses of several economic and financial indicators during those episodes, as well as this year. The charts are set up so that the blue lines represent the current EM selloff and the dotted lines in each panel represent how the same data series responded in 2013 (top panel of each chart) and 2014/15 (bottom panel of each chart). The vertical line represents the date of the trough in the U.S. dollar for each episode, which occurred in February 2018 for the current cycle. By looking at these charts, we can see how the current backdrop is evolving versus those prior episodes. The goal is to try to determine where things are similar, and different, to EM market declines in recent history. We are focusing on the areas where we believe there is the greatest concern over the potential spillovers from the current bout of EM stress - U.S. economic growth, Chinese economic growth and U.S. financial markets. We present the charts in a rapid "chartbook" format, with our overall conclusions at the end. Leading Economic Indicators: The OECD's leading economic indicator for the U.S. (Chart 6A) is currently off the high seen at the beginning of the year, following a path similar to 2014/15, but the latest data point has ticked higher. More importantly, the level is higher than at the same point in the 2013 and 2014/15 cycles. Meanwhile, the OECD (ex-U.S.) global leading economic indicator (Chart 6B) is following the depressed path of the 2014/15 episode, rather than the acceleration seen during the 2013 Taper Tantrum. Chart 6AU.S. Leading Indicator Following 2014/15 Path Chart 6BGlobal Leading Indicator Following 2014/15 Path U.S. Dollar: The rising dollar of 2018 (Chart 7A) looks more like the 2014/15 episode in terms of magnitude, although the greenback is at a lower level than during that earlier cycle (note that all lines are indexed to 100 at the date of the trough in the dollar at the vertical line). In 2013, the increase in the dollar was fairly mild, even with U.S. bond yields soaring higher, due to fact that non-U.S. growth was improving at the time. Chart 7AU.S. Dollar Following 2014/15 Path...So Far Chart 7BU.S. Investment Grade Returns Matching 2014/15 Path U.S. Corporate Bonds: The path of excess returns for U.S. investment grade corporate debt (Chart 7B) is tracking extremely tightly to the 2014/15 experience, with larger losses compared to this similar point during the Taper Tantrum. EM Equities & Credit: The widening in USD-denominated EM sovereign credit spreads in 2018 (Chart 8A) is in line with the 2014/15 cycle and has already surpassed the 2013 episode. The decline in EM equities (Chart 8B) has been worse than both prior EM selloffs. Chart 8AEM Equities Worse Than Both 2013 & 2014/15 Chart 8BEM Spreads Matching 2014/15 Path U.S. Interest Rates: Our 12-month fed funds discounter, which measures the amount of Fed rate hikes expected by the market over the next year, is higher than the 2014/15 episode and much higher than 2013 (Chart 9A). 10-year Treasury yields are at the same level as occurred at this point during the Taper Tantrum, and well above the levels seen in 2014/15 (Chart 9B). Chart 9AMore Fed Hikes Expected Than 2013 & 2014/15 Chart 9BUST Yields Following 2013 Path U.S. Labor Markets: Perhaps the biggest difference between the current backdrop and the prior EM selloffs is state of the U.S. labor market. The unemployment rate of 3.9% is much lower than the 5.6% rate seen during the 2014/15 cycle and the 7.6% level seen at this point during the Taper Tantrum (Chart 10A). That is translating to a faster pace of U.S. wage growth, measured by the annual percentage change in Average Hourly Earnings, than in either of the previous episodes of USD strength and EM turmoil (Chart 10B). Chart 10AMuch Lower U.S. Unemployment In 2018... Chart 10B...With Faster U.S. Wage Growth U.S. Inflation: Realized U.S. inflation, using core CPI, is higher now than in either of the previous episodes (Chart 11A). That can also been seen in the ISM Prices Paid index, which is far above the levels seen in both 2013 and 2014/15 (Chart 11B). Chart 11AHigher U.S. Inflation In 2018... Chart 11B...With Greater Inflation Pressures U.S. Economy: We can obviously show many charts here, but we think the most relevant are those related to signs that non-U.S. market turmoil and slowing growth is spilling back into the U.S. On that note, we show the ISM New Orders index in Chart 12A and the annual growth rate of total U.S. exports in Chart 12B. The New Orders index today is as strong as it was at this point during the Taper Tantrum, and much healthier compared to 2014/15 when New Orders were falling sharply. U.S. export growth is faster than both prior episodes, especially 2014/15 when exports contracted outright. Chart 12AStronger ISM New Orders In 2018... Chart 12B...With Healthier Export Demand China Economy: Again, we could use any number of data series in these charts, but we are keeping it simple and choosing indicators that show the impact of Chinese growth on the world economy. Chinese nominal GDP growth, currently at 9.8%, is the same as it was at this point in the 2013 cycle but much faster than during the 2014/15 period (Chart 13A). Importantly, however, China nominal GDP growth is decelerating now as it was in both of the prior episodes. Chinese annual import growth, up 19% in RMB terms, is faster now than in both prior periods of EM stress, especially compared to the contraction seen during the 2014/15 episode (Chart 13B). Chart 13AFaster, But Still Slowing, China GDP Growth Chart 13BStronger China Import Growth In 2018 U.S. Corporate Profits: Here is perhaps the biggest difference between today and the previous EM stress episodes. The annual growth in earnings-per-share for the S&P 500 rose to 18% in the 2nd quarter of this year, far above the zero growth rate seen at this point of the 2013 and 2014/15 cycles (Chart 14A). A big reason for the difference is the impact of the Trump corporate tax cuts this year, which has boosted operating margins well beyond levels seen in the prior two episodes (Chart 14B). Chart 14AFaster U.S. Profit Growth In 2018... Chart 14B...With Wider Margins Thanks To Tax Cuts EM Growth: An aggregate of EM Purchasing Managers Indices (PMIs) shows that the current bout of softer EM growth looks similar to the slowdowns in 2013 and 2014/15 (Chart 15A). In both prior cases, the PMIs eventually fell below 50, signifying economic contraction. In the 2013 episode, however, the PMI rebounded around the same point in the cycle as we are at today. Chart 15AEM Growth Slowing Similar To 2013 & 2014/15 Chart 15BU.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions: U.S. financial conditions are tighter now than the level seen at this point in the 2013 cycle and are as tight as witnessed at this point in the 2014/15 period (Chart 15B). After looking through all these charts, we can come up with the following conclusions: Chart 16Is It All Just "Q.T."? EM financial stress today is worse than 2013 and 2014/15 The U.S. economy is stronger today than in 2013 and 2014/15 U.S. external demand and corporate profits are both more robust today than in 2013 and 2014/15 U.S. inflation pressures are greater today than in 2013 and 2014/15 China's economy today, while slowing, is still growing faster than in 2013 and 2014/15 EM economic growth is slowing at the same pace as in 2013 and 2014/15. In terms of "benchmarking" where we are now compared to the previous two EM big EM selloffs, the fact that U.S. and Chinese economic growth is stronger today, and U.S. inflation is faster today, are the most important differences. This may even explain why U.S. markets are not reacting more negatively to the growing protectionist threats from the White house. Against this backdrop, it will require higher U.S. interest rates and a much stronger dollar before U.S. equities and credit markets finally suffer a serious pullback. In the end, though, the fact that U.S. and Chinese growth is better today does not suggest that a cautious investment stance is unwarranted. For the best correlation can be seen in our final chart (Chart 16), which shows the growth rate of the major developed market central bank balance sheets as a leading indicator of EM equity returns and developed market credit returns (and as a coincident indicator of government bond yields). If one were to only look at this chart, the weaker returns from global risk assets in 2018 can be fully explained by "quantitative tightening" and the resulting pullback in risk-seeking global capital flows compared the 2016/17. Bottom Line: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 204/15 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns