Gov Sovereigns/Treasurys
Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In January, the model outperformed global equities and the S&P 500 in USD terms, but underperformed in local-currency terms. For February, the model cut its weighting in stocks and increased its allocation to bonds (Chart 1). Within the equity portfolio, the weightings to both the U.S. and emerging markets were decreased. The model boosted its allocation to French bonds at the expense of Swedish and Canadian paper. The risk index for stocks, as well as the one for bonds, deteriorated in January. Feature Performance In January, the recommended balanced portfolio gained 1.4% in local-currency terms, and 3.6% in U.S. dollar terms (Chart 2). This compares with a gain of 3.2% for the global equity benchmark and a 2% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The performance of bonds was a detractor from the model's performance in local currency terms in January. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model decreased its allocation to stocks from 57% to 53%, and upgraded its bond weighting from 43% to 47% (Table 1). Table 1Model Weights (As Of January 26, 2017) The model increased its equity allocation to France, Italy, and Sweden by one point each. Meanwhile, weightings were cut by 2 points in the U.S., and by 1 point in Germany, Spain, Switzerland, Emerging Asia, and Latin America. In the fixed-income space, the allocation to French paper was increased by 6 points and the U.K. by 1 point. The model cut its exposure to Swedish bonds by 2 points and Canadian bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time we do provide our recommendations. The dollar weakened in January and our Dollar Capitulation Index fell close to neutral levels. Uncertainty over the size of the fiscal push by the U.S. administration could prolong the dollar's consolidation phase, especially if coupled with any negative economic surprises. However, this would only be a pause since continued monetary policy divergence should translate into another leg up in the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The deterioration of the value and cyclical components led to a higher risk index for commodities. The model continues to shun this asset class (Chart 4). The risk index for global equities increased to a 3-year high in January due to the deterioration in the value indicator. While the global risk index for global bonds also deteriorated, it remains firmly in the low-risk zone. The model slightly decreased its allocation in equities to the benefit of bonds (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk Following the latest uptick in the risk index for U.S. equities, the allocation to this asset class was trimmed. U.S. stocks have been propped up by the growth-positive aspects of the new U.S. administration's policies and are at risk should this optimism deflate (Chart 6). The risk index for Canadian equities improved slightly in January as the better readings in the liquidity and momentum indicators offset continued worsening in value. That said, the overall risk index remains at the highest level in this business cycle. This asset remains excluded from the portfolio (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Canadian Stock Market And Risk The risk index for U.K. equities deteriorated, reaching a post-Brexit high. For the first time in over two years, the value component crossed into expensive territory (Chart 8) The model trimmed its allocation to Emerging Asian stocks following the slight uptick in the risk index. While the global reflationary pulse should bode well for this asset class, rumblings about protectionism threaten to de-rate growth expectations (Chart 9). Chart 8U.K. Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk The unwinding of oversold conditions was the main reason behind the deterioration in the risk index for bonds in January. However, the latter is still in the low-risk zone as the bond-negative reading from the cyclical indicator remains overshadowed by the ongoing oversold conditions in the momentum indicator (Chart 10). The risk index for U.S. Treasurys deteriorated in January on the back of a less-stretched momentum indicator. While the cyclical backdrop is bond-bearish, there is arguably more room for scaling down optimism over the economy than there is to having an even more upbeat outlook. As a result, any resumption of the rise in Treasury yields could end up being very gradual (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The risk index for euro area government bonds also deteriorated in January, but unlike the U.S., it is in the high-risk zone. There are notable differences in the risk readings within euro area markets (Chart 12). Given the upcoming presidential elections, France is next in line in terms of investors' focus on political risks. French bonds are heavily oversold based on the momentum indicator, pushing the overall risk index lower. An unwinding of the risk premium would bode well for French bonds, which the model upgraded in January (Chart 13). Chart 12Euro Area Bond Yields And Risk Chart 13French Bond Yields And Risk The risk index for Spanish government bonds ticked down slightly reflecting minor improvements in all three of its components. However, it remains much higher than the risk index for the French paper, which is preferred by the model (Chart 14). With the risk index little changed in January, Swiss government bonds remain in the high-risk zone. The model continues avoiding this asset which possesses negative yields (Chart 15). Chart 14Spanish Bond Yields And Risk Chart 15Swiss Bond Yields And Risk Currency Technicals The dollar depreciated after the 13-week momentum measure indicated last month that the greenback could face near-term resistance. Further consolidation cannot be ruled out, but the 40-week rate of change measure is not signaling an end to the dollar bull market. The monetary policy divergence between the Fed and its peers provides underlying support for the dollar, while heightened uncertainty on the fiscal front implies more volatility going forward (Chart 16). EUR/USD was not able to stay below 1.05. The short-term rate-of-change measure is approaching neutral levels, which could test the EUR/USD bounce. A risk-off episode or continued solid economic data are two factors that could provide some support for the euro in the near term (Chart 17). The 40-week rate of change measure for GBP/USD continues to hover near the most oversold level since 2000 (excluding the great recession). Meanwhile, the 13-week momentum measure crossed into positive territory, but is not extended. The pound will remain event-driven and possibly range-bound in the near term as the mood bounces within the hard Brexit / soft Brexit spectrum (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Euro Chart 18Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights Undue pessimism about global growth is giving way to unbridled optimism. Chinese growth has accelerated. However, there is a risk that the economy hits a speed bump later in 2017, as fiscal policy becomes less accommodative, monetary policy is tightened in an effort to curb capital outflows, and recent steps by the authorities to crack down on rampant speculation in the property sector begin to bite. The threat of a trade war will also loom large. U.S. fiscal policy will remain stimulative, but may fail to live up to expectations: There is little appetite among Republicans for increasing infrastructure spending; the multiplier effects from the proposed tax changes are likely to be small; and many GOP leaders are already chomping at the bit to take an ax to government spending. Fortunately, the U.S. economy has enough momentum to continue growing solidly above trend, even if fiscal policy disappoints. This will allow the Fed to raise rates three times this year, one more hike than the market is currently pricing in. Developed market equities are overbought and vulnerable to a correction, but will be higher 12 months from now. Favor Europe and Japan over the U.S. in local-currency terms. Stay underweight EM. Feature Global Growth Is Accelerating, But Headwinds Persist The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators (Charts 1 and 2). Chart 1Global Economy ##br##Springing Back To Life Chart 2Global Leading Economic ##br##Indicators Are Improving Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years (Chart 3). We agree with the market's positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: A slowing of China's economy later this year. The possibility that U.S. fiscal policy will end up being less stimulative than expected. China: Living On Borrowed Time? Chinese growth has been surprising to the upside of late (Chart 4). Timely indicators such as excavator sales and railway freight traffic, which are well correlated with industrial activity, have been rising at a fast clip. Manufacturing inventory levels have come down, corporate profitability has improved, and producer price inflation has turned positive. The labor market has also picked up steam, as evidenced by the expansion in the employment subcomponents of the PMI indices. Chart 3Market's Positive Re-Rating Of Growth Prospects Chart 4Chinese Growth Has Been Surprising To The Upside Looking out, however, there are reasons to worry that the economy will weaken anew. Growth in government spending slowed from a high of 25% in November 2015 to nearly zero in December (Chart 5). Recent efforts by policymakers to clamp down on rampant property speculation could also cause the economy to cool. Meanwhile, capital continues to flee the country (Chart 6). This has put the government in a no-win situation: Raising domestic interest rates could entice more people to keep their money at home, but such a step could increase debt-servicing costs and undermine the country's creaky financial system. Chart 5China: Fiscal Stimulus Is Running Off Chart 6China: Ongoing Capital Outflows A Problem Of Inadequate Demand There is no shortage of commentary discussing the problems that ail China. Much of the analysis, however, has focused on the country's inefficient allocation of resources and other supply-side considerations. While these are obviously important issues, they overlook what has actually been the most significant binding constraint to growth: a persistent lack of aggregate demand. It has been this deficiency of demand - the flipside of a chronic excess of savings - that has kept the economy teetering on the edge of deflation. If a country suffers from excess savings, there are only three things that it can do. First, it can try to reduce savings by increasing consumption. The Chinese government has been striving to do that by strengthening the social safety net in the hopes that this will discourage precautionary savings. However, this is a slow process which will take many years to complete. Second, it can export those excess savings abroad by running a current account surplus. This would allow the country to save more than it invests domestically through the famous S-I=CA identity. The problem here is that no one wants to have a large current account deficit with China. Certainly not Donald Trump. Third, it can channel those excess savings into domestic investment. This is what China has done by pressing its banks to extend credit to state-owned companies and local governments. Remember that debt is the conduit through which savings is transformed into investment. From this perspective, China's high debt stock is just the mirror image of its high savings rate. The problem is that China already invests too much. Chart 7 shows that capacity utilization has been trending lower over the past six years and is back down to where it was during the Great Recession. The good news is that as long as there is plenty of savings around, Chinese banks will have enough liquid deposits on hand to extend fresh credit. The bad news is that there is no guarantee that borrowers taking on this debt will be able to repay it. This has made the Chinese economy increasingly sensitive to changes in financial conditions. And that sensitivity has, in turn, made global financial markets more fragile. Chart 8 shows that global equities have sold off whenever China stresses have flared up. The risk of another such incident remains high. Chart 7China: Capacity Utilization Back ##br##To Pre-Recession Levels Chart 8When China Has a Cold, ##br##Global Equities Sneeze China Trade War: The U.S. Holds The Trump Card Chart 9China Would Suffer More ##br##From A Trade War With The U.S. Adding to the pressure on China is the prospect of a trade war with the United States. Donald Trump has flip-flopped on almost every issue over the years, but he's been perfectly consistent on one: trade. Trump has always been a mercantilist at heart, and nothing that has happened since the election suggests otherwise. It is sometimes argued that the damage to the U.S. economy from a trade war with China would be so grave that Trump would not dare initiate one. This is wishful thinking. Chinese exports to the U.S. account for 3.5% of Chinese GDP, while U.S. exports to China account for only 0.6% of U.S. GDP (Chart 9). And much of America's exports to China are intermediate goods that are processed in China and then re-exported elsewhere. Blocking these exports would only hurt Chinese companies. Yes, China could threaten to dump its huge holdings of U.S. Treasurys. However, this is a hollow threat. The yield on Treasurys is largely determined by the expected path of short-term interest rates, which is controlled by the Federal Reserve. To be sure, the dollar would weaken if China started selling Treasurys. But why exactly is that a problem for the U.S.? Donald Trump wants a weaker dollar! In short, the U.S. would not lose much by provoking a trade war with China. Where does this leave us? The most likely outcome is that China blinks first and takes more concerted steps to open up its market to U.S. goods. This would hand Donald Trump a major political victory. However, the path from here to there is likely to be a very rocky one, which means that the reflation trade could suffer a temporary setback. A Trumptastic Fiscal Policy? Getting tough with China was one of Trump's key campaign promises; increasing infrastructure spending and cutting taxes was another. Unfortunately, investors may end up being disappointed both by how much fiscal stimulus is delivered and by the bang for the buck that it generates. For starters, much of Trump's proposed infrastructure program may never see the light of day. The $1 trillion ten-year program that he touted during the campaign was scaled back to $550 billion on his transition website. And even that may be too optimistic. Most Republicans in Congress have little interest in expanding public infrastructure spending. They opposed a big public works bill in 2009 when millions of construction workers were out of a job, and they will oppose one now. The public-private partnership structure that Trump's plan envisions will also limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Granted, the definition for what counts as public infrastructure could be expanded to include such things as hotels and casinos, to cite two completely random examples. But even if one ignores the obvious governance problems that this would raise, such a step could simply crowd out private investment that would otherwise have taken place. The reason that governments invest in infrastructure to begin with is because there are certain categories of public goods that do not lend themselves well to private ownership. To purposely exclude such goods from consideration, while devoting public funds to projects that the private sector is already perfectly capable of doing, is the height of folly. Trump And Taxes House Republicans are pursuing a sweeping tax reform agenda. There is much to like about their proposal. In particular, the shift to a cash flow destination-based tax system could encourage new investment over time, while making it more difficult for firms to carry out a variety of tax-dodging strategies. However, as with many major policy initiatives, the Republican tax proposal could generate significant near-term economic dislocations. Most notably, as we discussed in detail last week, the inclusion of a border adjustment tax could lead to a sharp appreciation in the dollar.1 This would benefit foreign holders of U.S. assets, but hurt debtors with dollar-denominated loans. Such an outcome could put stress on emerging markets, potentially undermining the global reflation trade. Trump's proposed cuts to personal income taxes may not boost spending by as much as some might hope. The Tax Policy Center estimates that the top one percent of income earners will see their after-tax incomes increase by 13.5%, while those in the middle quintile of the distribution will receive an increase of only 1.8% (Table 1). Since the very rich tend to save much of their income (Chart 10), measures which boost their disposable income may not translate into a substantial increase in spending. In fact, cutting the estate tax, as Trump has proposed, could actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Table 1Trump's Proposed Tax Cuts Would Largely Favor The Rich Chart 10Savings Heavily Skewed Towards Top Earners Spending Cuts On The Horizon? Then there is the question of whether Congressional Republicans will try to take an ax to government spending. The Hill reported last week that several senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years.2 The plan contains many of the same elements as the Republican Study Committee's Blueprint for a Balanced Budget, which called for $8.6 trillion in cuts over the next decade. Separately, Representative Sam Johnson of Texas, the chairman of the House Ways and Means subcommittee on Social Security, has introduced legislation seeking large cuts to pension benefits. Under his plan, workers in their mid-thirties earning $50,000 per year would see a one-third reduction in lifetime Social Security payments.3 Paul Ryan and other Congressional Republicans have also begun to argue that the goal of health care reform should be to guarantee "universal access" to high-quality medical care, rather than "universal coverage." This is a bit like arguing that the goal of transportation policy should be to ensure that everyone has access to a Bentley, provided that they can pony up $200,000 to buy one. It remains to be seen whether President Trump will acquiesce to these changes. He has repeatedly insisted that no one will lose medical coverage under his administration. However, one of his first actions in office was to loosen the mandate that requires healthy individuals to purchase insurance under the Affordable Care Act. Such a measure, however well intentioned, could greatly undermine the Act. If healthy people can wait until they are sick to sign up for insurance, only sick people will sign up. In order to cover their costs, insurance providers would have to raise premiums, ensuring that even fewer healthy people sign up. Such a vicious "adverse selection cycle," as economists call it, could lead to the collapse of health insurance exchanges, which currently provide coverage for 12.7 million Americans. Our guess is that Trump will ultimately put the kibosh on any plan to radically cut government spending or curtail Medicare and Social Security benefits. Say what you will of Trump, he has proven to be a skilled political operator for someone who has never been elected to public office. He knows that people were chanting "build the wall" at his rallies, not "cut my Medicare." Indeed, it is possible that Trumpcare will ultimately look a lot like Obamacare but with more generous subsidies for health care providers. Nevertheless, the path to this more benign investment outcome will be a bumpy one, suggesting that market volatility could rise in the months ahead. Investment Conclusions Chart 11DM Stocks Are Overbought Markets tend to swing from one extreme to another. This time last year, investors were fixated on secular stagnation. Now they are convinced that we are on the edge of a new global economic boom. Neither position is justified. Global growth has picked up, and this should provide a tailwind to risk assets over the next 12 months. However, as this week's discussion makes clear, there are still plenty of headwinds around. This suggests that the recovery will be a halting affair, with plenty of setbacks along the way. The surge in developed market equities since the U.S. presidential election has pushed stocks deep into overbought territory (Chart 11). A correction is likely over the next few weeks. We expect global equities to fall by 5%-to-10%, paving the way for higher returns over the remainder of the year. Once that recovery begins, European and Japanese stocks will outperform their U.S. counterparts in local-currency terms. We continue to expect EM equities to lag DM. In contrast to stocks, bond yields have already moved off their highs. As we discussed in our Strategy Outlook in early January, the transition from deflation to inflation will be a protracted one.4 Nevertheless, the path of least resistance for yields is to the upside. The Fed is likely to raise rates three times this year, one more hike than the market is currently pricing in. This should be enough to keep the dollar bull market intact. We expect the trade-weighted dollar to rise another 5% by year-end, with the risk tilted to the upside if Congress ends up approving a border adjustment tax. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 2 Please see Alexander Bolton, "Trump Team Prepares Dramatic Cuts," The Hill, dated January 19, 2017. 3 Please see Stephen C. Goss memorandum to Sam Johnson, "Estimates Of The Financial Effects On Social Security Of H.R. 6489, The 'Social Security Reform Act Of 2016,' Introduced On December 8, 2016 By Representative Sam Johnson," Social Security Administration, Office Of The Chief Actuary (December 8, 2016). 4 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. 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 * 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 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. 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-7Indicators To Watch##br## - Interest Rate Expectations
Highlights Duration: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. Fed Balance Sheet: The Fed could start to reduce the size of its balance sheet as early as the end of this year, but more likely in 2018. In any case, allowing securities to run off its portfolio will not have much of an impact on long-dated Treasury yields. MBS: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Feature As we pointed out in our December 6 report, the bond selloff had proceeded too far, too fast, and was due for a pause. The 10-year Treasury yield then peaked at 2.6% on December 16 and has now fallen back to 2.4% as we go to press. It is of note that all of the reversal has come from the real component of yields while the compensation for expected inflation has remained firm (Chart 1). Chart 1Bear Market On Pause In our end-of-year "Themes For 2017" Special Report 1 we explained why we believe Treasury yields will level-off in the near term before heading higher throughout most of 2017. Now that we have entered this first "consolidation phase" it is time to consider what factors would cause us to reinstate a below-benchmark duration stance. But first, let us quickly recap our bearish 6-12 month outlook for Treasuries. The Cyclical Outlook For Treasury Yields Many of the headwinds that held back economic growth last year - including fiscal policy, inventory drawdowns and the impact of a distressed energy sector on capital spending - are poised to abate in 2017. With stronger growth and an already tight labor market, core inflation will continue to gradually rise toward the Fed's target. We expect trailing 12-month core PCE inflation will reach the Fed's 2% target near the end of 2017. Consequently, the cost of inflation protection embedded in bond yields will also converge with levels that are consistent with the Fed's target (Chart 2). We judge this level to be in the range of 2.4% to 2.5% for long-dated TIPS breakevens. With the 5-year/5-year forward TIPS breakeven rate at 2.13% and the 10-year TIPS breakeven rate at 2%, long-dated Treasury yields have approximately 30-50 bps of upside from the inflation component alone. Chart 2Breakevens Still Too Low Chart 3Real Yields Also Biased Higher We are less certain about how much higher real yields might move during the next 12 months. However, the downside in real yields is surely limited. Chart 3 shows that changes in the 10-year real yield and changes in our 12-month Fed Funds Discounter2 are almost always positively correlated. At present, the reading from our discounter is 46 bps, meaning the market is priced for about 2 more rate hikes during the next 12 months. Given our positive economic outlook, 2 or 3 rate hikes in 2017 sounds reasonable. Is Now The Time To Trim Duration? Barring any major economic setbacks we will consider three factors when making this decision: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation When we last shifted from a below-benchmark to a benchmark duration stance on December 6 the 10-year Treasury yield traded 14 bps above the fair value reading from our 2-factor Global PMI Model. At present, the 10-year yield is only 9 bps cheap on this model (Chart 4). In other words, valuation is essentially neutral. But since global PMI is likely to trend higher over the course of the year, we would be comfortable cutting duration at current valuation levels should the other two factors on our checklist fall into place. Factor 2: Uncertainty We've been talking a lot about uncertainty recently, mostly in reference to the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index exhibits a strong inverse correlation with Treasury yields over time and has shot higher during the past couple of months without a corresponding decrease in yields. When we consider the uncertainty index alongside Global PMI and bullish sentiment toward the U.S. dollar in our 3-factor model of Treasury yields, we find that the 10-year Treasury yield now appears 38 bps cheap (Chart 5). Chart 4Close To Fair Value... Chart 5...But Uncertainty Remains Elevated What is particularly odd is that the uncertainty index has diverged so sharply from measures of both consumer and small business confidence (Chart 6). This epic split can mean only one of two things: Chart 6Excessive Optimism Or A False Reading From The Uncertainty Index? Businesses and consumers are excessively optimistic in the face of an increasingly uncertain back-drop, or The uncertainty index is unable to distinguish between policy shocks with positive and negative economic implications We turn to history in an attempt to determine whether the warning from the uncertainty index should be heeded. Specifically, we searched for other one-month periods when there was a one standard deviation increase in the uncertainty index alongside increases in both consumer and small business confidence. Since 1991, ten months meet these criteria (Table 1). Table 1Periods Displaying One Standard Deviation Increase In Global Economic Policy##br## Uncertainty Index* And Increase In Both Consumer Sentiment Index** ##br##And Small Business Confidence Index*** (1991 To Present) First we note that Treasury yields declined in 7 out of the 10 flagged periods, but in many of those episodes the scale of the positive confidence shocks was not very large. The two months that appear most similar to the present situation are September 2008 and December 2013. Chart 7Investors Still Bearish The Fed announced the tapering of its asset purchases in December 2013 amidst signs of an improving economy. The hawkish Fed announcement and improving economic outlook sent yields higher on the month, while the uncertainty index spiked as a large number of Fed-related news stories hit the papers.4 One thing that makes December 2013 an imperfect comparable to the present day is that the uncertainty shock was relatively small compared to the confidence shocks. In September 2008 the confidence shocks were not as large as the uncertainty shock, much like today, and the 10-year Treasury yield managed a 2 bps increase. However, it is definitely unfair to draw a conclusion based on the extremely volatile price movements that were witnessed at the height of the financial crisis in September 2008. Based on the example of December 2013, we cannot decisively rule out the possibility that the uncertainty index is simply giving a false signal. However, if that is the case we would expect the uncertainty index to mean revert in relatively short order. Given the strong historical relationship between the uncertainty index and Treasury yields, we will wait for some mean reversion in the uncertainty index before shifting back to a below-benchmark duration stance. Factor 3: Sentiment & Positioning When we shifted from a below-benchmark to a benchmark duration stance measures of investor sentiment and positioning were at bearish extremes, sending a decisive signal that the bond market was oversold. As of today, some of these indicators have started to reverse course while others have not (Chart 7). Our BCA Bond Sentiment Indicator, a composite of a survey of bullish sentiment toward bonds and the 13-week rate of change in bond yields is no longer at an oversold extreme. However, net speculative positions in the 10-year Treasury futures contract have moved even further into "net short" territory. The J.P. Morgan client survey shows that investors remain below benchmark duration in aggregate, although active traders are no longer net short. Although some capitulation of shorts has already taken place, we will await some further normalization of positioning - particularly in net speculative futures - before reinitiating a below-benchmark duration stance. Bottom Line: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. The Fed's Balance Sheet & The Shortage Of Bills The minutes from December's FOMC meeting revealed that: Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities Since then, three different FOMC members have also spoken about the size of the Fed's balance sheet. Philadelphia Fed President Patrick Harker said that the Fed should consider shrinking its balance sheet once the fed funds rate reaches 1%.5 Boston Fed President Eric Rosengren made the case for more immediate action6 and St. Louis Fed President James Bullard said the Fed should consider shrinking its balance sheet in 2017.7 Clearly, talk of unwinding the Fed's balance sheet is heating up. The Fed's only official stated position on this topic is that it will keep its balance sheet level until normalization of the fed funds rate is "well under way", a statement we have long interpreted to mean "until the fed funds rate is 1%, or perhaps even higher". As such, we would not expect any action on winding down the Fed's balance sheet until late this year at the earliest, and more likely in 2018. The Impact On Treasury Yields In any case, as we detailed in a report published in August 2015,8 we do not think that the Fed allowing its balance sheet to shrink will itself have much of an impact on Treasury yields. The reason relates to the way in which maturing Treasury securities are currently rolled over at auction and the persistent shortage of T-bills in the market. Chart 8Fed Runoff Will Increase##br## Issuance To Public ... At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426 bn in 2018 and $378 bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 8). We contend, however, that a significant portion of this extra financing requirement will be met through increased T-bill issuance and will therefore not impact long-dated Treasury yields. The Treasury department has had a stated goal of increasing T-bill issuance since May 2015 and bill supply as a percentage of total Treasury debt remains near a multi-decade low (Chart 9). Further, T-bills are still in high demand as evidenced by the fact that they are trading at a substantial premium to other money market instruments (Chart 10). This premium exists despite the fact that the Fed has been soaking up a lot of T-bill demand through its Overnight Reverse Repo facility (Chart 10, bottom panel). If the Fed were to phase this program out alongside a reduction in the size of its balance sheet - which is its current stated exit strategy - the shortage of T-bills would be exacerbated. Chart 9... But Mostly Through T-Bills Chart 10T-Bills In High Demand Of course there is a new regime about to enter the White House and the Treasury department, and also a lot of uncertainty about how large the deficit will be going forward. If the deficit is increased substantially then it would likely be necessary for the Treasury department to increase the size of both bill and coupon issuance in the years ahead. Bottom Line: It is necessary to consider both fiscal policy and the Fed's balance sheet together when forecasting Treasury issuance. Further, whatever the government's financing requirement, a considerable portion of it will be addressed through increased T-bill issuance in the years ahead. This will limit the impact on long-dated Treasury yields. A Quick Note On MBS Chart 11MBS Spreads Are Too Low Any unwind of the Fed's balance sheet will have a much greater impact on MBS spreads than on Treasury yields since it will add directly to the supply of MBS available to the public, which tends to correlate with MBS option-adjusted spreads (Chart 11). Of course, other factors such as the rate of prepayments will determine how quickly the Fed's MBS holdings run off and the state of the housing market will determine how much new mortgage origination takes place. We hope to explore these issues in more depth in the coming weeks. Of more immediate concern for MBS spreads though is the recent divergence between nominal spreads, rate volatility and the slope of the yield curve (Chart 11, bottom two panels). MBS spreads have not widened in recent weeks despite curve steepening and rising rate vol. MBS spreads are already low compared to investment alternatives and have upside in the near term, especially if the yield curve continues to steepen, as we expect it will. Looking further out, the eventual wind down of the Fed's balance sheet is another risk the MBS market will have to face. Bottom Line: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 207", dated December 20, 2016, available at usbs.bcaresearch.com 2 Our 12-month discounter measures the expected change in the fed funds rate during the next 12 months as discounted in the overnight index swap curve. 3 www.policyuncertainty.com 4 The uncertainty index is in part based on an algorithm that scans newspapers for coverage of policy-related economic uncertainty. 5 http://www.reuters.com/article/us-usa-fed-harker-idUSKBN14W1W4 6 http://www.cnbc.com/2017/01/09/reuters-america-interview-rosengren-urges-more-rate-hikes-slimmer-balance-sheet.html 7 http://www.businessinsider.com/lets-shrink-the-balance-sheet-bullard-says-2016-12 8 Please see U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * 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 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-12 Chart I-13 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