Policy
Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Chart I-5... And ##br##The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. 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-13 * 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-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights The U.S. Border Adjustment Tax is likely to pass; Yet the political pieces are not in place; Trump himself will be the decisive factor; Trade retaliation would detract from trade benefits of the tax; Stay long volatility; small caps versus large caps; and long USD versus EM currencies. Remain short China-exposed S&P 500 stocks, and German exporters versus consumer services. Feature Donald Trump is a trend-setter. After winning the U.S. election on a protectionist platform that played well to voters in the Midwest, Trump has established an anti-globalization brand of politics. His success has revealed the preferences of the American "median voter."1 Other U.S. politicians are taking notice. The "Border Adjustment Tax" (BAT) is part of this new political trend, though it did not originate with Trump. The House GOP leadership has presented it as a response to economic dislocation in the American heartland, which propelled Trump to the White House. Is it protectionism? Yes, and in this analysis we explain why. The rest of the world is highly unlikely to treat the BAT as a standard Value Added Tax (VAT). It will therefore spark trade retaliation unless Congress addresses outstanding issues. So far President Trump is on the fence, and his support is necessary for passage. We think he will ultimately go with the proposal. The prospect of turning the tables on the U.S.'s trade partners, while spurring domestic investment and capital spending, speaks to his core promises to his voters. Trump's support for the plan should be read as a headwind for markets in the short term due to the uncertainties of implementation and trade disputes. If he should oppose the plan, it would be bullish for U.S. stocks in the short term, since it would mean cutting the corporate tax without radically altering the global status quo. It would signal that he is more interested in economic growth and corporate profits than changing the world or balancing the U.S. budget. Why Reform The Corporate Tax System? American policymakers have long struggled with the country's corporate income tax system. Leaving aside party politics, there are three main complaints:2 Corporate tax revenues are weak: Revenues have disappointed as companies have shifted profits to tax havens and used deductions and loopholes to avoid paying the 35% statutory rate. This erosion of the tax base has contributed to budget deficits as well as public dissatisfaction with governing institutions (Chart 1). U.S. companies have lost competitiveness: American businesses are overtaxed relative to their developed-market peers, taking a toll on competitiveness both at home and abroad (Chart 2). The middle class is losing out: U.S. workers are not as well compensated as their developed-market peers and have lost their share of American wealth in recent decades (Chart 3). The corporate tax contributes to this because companies foist the tax onto workers. Chart 1Over-Taxation Is In##br## The Eye Of The Beholder Chart 2U.S. Competitiveness##br## Has Suffered Chart 3Labor Suffers From##br## High Corporate Tax Rates The Republican Party examined fundamental tax reform in 2005 but could not make progress on it - instead it settled for the Bush tax cuts, which focused primarily on cutting household tax rates.3 Now that the Republicans have control of all three branches of government again, its leaders are attempting broad tax reform anew. The GOP is primarily concerned with corporate competitiveness, but they also need to appease the middle class - the source of the populist angst that supported both Obama and Trump (the former being the Republicans' arch-nemesis, the latter a strange bedfellow). The GOP also wants to raise some revenue to make their desired tax rate cuts "revenue neutral," i.e. somewhat fiscally defensible, at least enough to pass the bill. Enter Paul Ryan, Speaker of the House, and Kevin Brady, Chairman of the Ways and Means Committee, and their "Better Way" tax plan, which proposes a sweeping overhaul of the U.S. tax system.4 The core idea is to pay for tax cuts by transforming the current corporate income tax system into a "destination-based cash-flow tax" (DBCFT) with border adjustability ("border adjustment tax" or BAT for short).5 We will get to the definition of that, but first, what is the ultimate point? The plan would purportedly drive corporate investment and economic growth by allowing companies to write off the expense of new investments immediately, the first year, rather than gradually through depreciation. (Depreciation schedules often mean that the tax write-off barely covers the cost of investment, thereby causing companies to err on the side of risk-aversion.) The plan would also remove the preferential treatment of corporate debt over equity, which is built into the current tax code through the deduction of interest - this change would discourage corporate indebtedness and encourage equity financing. Finally the plan would not allow U.S. companies to write off the expense of imported goods, as currently, and as such is essentially a tax on the U.S. trade deficit. Roughly, it could yield about $108 billion in revenue (assuming a 20% rate on the $538 billion deficit). The BAT is the chief tax uncertainty today for investors. That is because there are few constraints on the GOP passing some kind of corporate tax cut this year. Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. There is every reason to think it will happen fast. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power In other words, Trump and his party would need to have a train wreck to fail to pass something this year. That is not beyond belief! But the overriding question is whether the tax reform will be focused on cutting rates, or transforming the system. Currently, the market seems to think the BAT will go through. A basket of stocks based on potential winners and losers suggests that investors believe it will pass (Chart 4). Meanwhile, however, the share prices of high-tax companies (who should benefit the most if taxes are cut) have fallen back from the pop after Trump's election. This could signal the opposite expectation, or that that investors recognize that many high-tax sectors stand to lose from a tax on imports (Chart 5). There is considerable uncertainty in this measure. We think the Trump administration will ultimately accept the House GOP's BAT proposal. But the road between here and there will be tortuous, as past attempts at tax reform show. We expect dollar volatility, which is relatively restrained at present, to rise as the BAT debate intensifies, given that the proposal is bullish for the greenback (Chart 6). Chart 4Exporters Think Border##br## Adjustment Tax Will Pass Chart 5High-Tax Companies##br## Fear Policy Disappointments Chart 6No Border Adjustment##br## Tax Effect On The Dollar Yet Bottom Line: The Trump administration and GOP would have to be unusually incompetent to fail to achieve tax reform this year. The question is whether it will be mere rate cuts or a radical reform to the tax system as a whole. This is critical to the U.S. and global economy - especially given that the passage of a BAT will intensify trade disputes with the U.S. Why Is A Border Adjustment Tax "Protectionist"? Diagram 1 provides a simple illustration of how the current U.S. corporate tax works compared to the proposed BAT. The current system is a "worldwide" corporate income tax. The U.S. government taxes American companies based on their global profits (global revenues minus global costs). No matter where they incur costs, they can write them off, and no matter where they make profits, they must pay tax on them, at least in principle. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax The new system, by contrast, would be a "destination-based" tax in which the government taxes companies only on domestic profits (domestic revenues minus domestic costs). This means that revenues earned abroad from exports or sales in foreign jurisdictions would be free from tax. However - and here is the tricky part - it also means that costs incurred abroad, imports or purchases in foreign jurisdictions, would be ignored by the tax authority, i.e. they could not be written off like domestic costs. As the "rebate" in the Diagram shows, the BAT is effectively a tax on imports and subsidy to exports. This is not as egregiously protectionist as it sounds at first, because it is very similar to a Value-Added Tax (VAT), which is the dominant tax system across the world. The U.S. is a massive outlier for not having a VAT. But notice that the amount of the rebate to the exporting company in the diagram is higher (at $40) than the amount of tax that would be due if it paid a tax on its foreign profits, since ($200 - $100) x 20% = $20. The WTO may rule against the law if it believes major U.S. exporters will pay net negative taxes as a result of the rebate. Moreover, the BAT has certain differences from a VAT that ensure that the world will see it as a protectionist affront. The BAT is a combination of a VAT, which is a tax on consumption, and an income tax, which is the current system. However, the BAT would allow companies to write off wages and salaries as costs, just like under the current system. Under VAT systems, this is not possible because wages are not consumption and therefore not deductible.6 If the GOP proposal becomes law without addressing this difference - that is, without denying corporates the wage deduction, or taxing them in some other way to compensate - it will likely prompt global trade retaliation. While the World Trade Organization may deem the BAT legal by interpreting it as a VAT, it will not do so if U.S. companies cannot show that they are not getting a leg up on their international rivals by retaining the wage deduction from the former corporate income tax code. Wages are obviously a very large part of a company's expenses. They make up about 68-72% of U.S. companies' costs (Chart 7), and have grown at about 2-4% each year for the export-oriented sector (Chart 8). If U.S. companies can write off the wage expense in their exported goods, then foreign countries will have to adjust, possibly by imposing duties to counteract the share of taxes avoided by that write-off. Chart 7Wages Make For A Large Tax Deduction Chart 8Exporters Face Strong Growth In Wages Bottom Line: The BAT is a hybrid of tax systems. It is likely that the WTO and U.S. trading partners will object to it as an import tax and export subsidy, particularly because of the wage deduction. The House GOP could adjust the proposal ahead of time or afterwards to avoid this conflict, but that has not happened yet. In addition, corporate lobbying against removing wage deductions would be severe. Will A BAT Get Passed Into Law? Currently, the House GOP leaders face a rising wave of criticism about the BAT proposal and have begun to signal greater flexibility in drafting the law so as to win over various stakeholders. A salient point to remember about U.S. tax legislation is that it is very rare in recent decades for a ruling party to bungle it. Only eight pieces of tax legislation have been vetoed by presidents since 1975, only two of which were serious bills, and in both cases the president vetoed the legislation pushed by an opposition-controlled Congress (Table 2). By the time a serious tax bill makes it to the president's desk, a veto is unlikely, especially if the president and Congress belong to the same party. Table 2Major Tax Legislation Is Set Up For Success Even more salient, only 23 pieces of tax legislation since 1975 have been struck down in either of the two houses. Of these, seven were attempts to amend the constitution (not likely to pass), nine were attempts to amend the internal revenue code for highly specific things (spirits, cigars, the holding of conventions on cruise ships). Only seven were major bills, and in only one of these cases did the Senate strike down the bill, which was a case of a Republican Senate defending a Republican president from an opposition Congress. In only one case did the ruling party in the House kill a serious tax bill proposed by one of its own members, but it is not comparable to the tax reform in question today.7 What this means is that the BAT is highly likely to be passed into law if the House remains loyal to its leader Paul Ryan, and to the Ways and Means Committee chair Kevin Brady, the two authors of the BAT proposal. However, Trump could derail Ryan's best laid plans. Trump seemed to throw a wrench in the gears when he cast doubt on border adjustment tax, saying that it was too complicated. However, the Trump administration has recently made comments favorable to the BAT. Peter Navarro, chief of the new National Trade Council, highlighted it as a way to bring manufacturing supply chains back into the U.S. (note the protectionist angle of the comment). Meanwhile Sean Spicer, Trump's spokesman, said it would be a good way to make Mexico pay for the infamous wall to be constructed on the border (again, note that the angle is protectionist and populist, not about balancing the budget).8 In each case, the Trump team has gone to pains to emphasize that the BAT is only one option among many. Yet the fact that they have repeatedly brought it up as a solution to their own populist promises is suggestive. We think Trump will ultimately hew to the Republican Party leadership on tax reform.9 Why? Time's a'wastin': Party control of all three branches is a fleeting boon and 2018 mid-term campaigning would make the BAT harder to pass because it could hike the prices of consumer goods. Republicans have a plan ready to go, the House ultimately controls the purse, and Trump wants to move fast on tax cuts and boosting the economy. Furthermore, Republicans remember how short-lived the Democrats' control of Congress was after 2008. Trump wants to be transformative, not merely transactional:10 Trump was elected in a populist revolution and has vowed to improve American manufacturing and trade. His protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT: remove the "tax" on corporate investment to improve U.S. capital stock and productivity, and remove incentives to locate, operate, and stash profits offshore. There is at least some positive correlation between higher VAT rates and positive trade balances, and the law is simultaneously supposed to boost productivity (Charts 9 and 10). Chart 9Higher Investment Helps Productivity Chart 10Some (Not Much) Correlation Between Value-Added Tax Rates And Trade Surpluses Trump needs domestic and international "legitimacy": His protectionist platform will stand on firmer ground if he adopts policy that is at least debatable at the WTO, as opposed to imposing tariffs willy-nilly through bare executive power, which is eventually vulnerable to congressional and judicial oversight. Domestic courts have already shown an inclination to halt Trump's controversial executive orders.11 By contrast, they would almost certainly defer to Congress even on the most radical tax reforms. Trump needs a tradeoff for infrastructure spending: Unpopular presidents cannot set the legislative agenda.12 But Trump may be able to trade GOP-style corporate tax reform - which offsets tax cuts with new revenue provisions, such as the BAT - in return for infrastructure spending, which the GOP is reluctant to embrace. Trump is willing to lead a crusade against the WTO: This may be a necessary prerequisite for the passage of this bill, and Trump is heaven-sent to play the role. He would be to the WTO what George W. Bush was to the United Nations. It would be disastrous for the U.S.-built international liberal order, but it would give Trump the ability to pursue protectionism while rallying the public around the flag against America's "globalist" enemies. (Sovereignty over taxation is a cause that is hard to beat in the U.S.)13 BAT allows Trump to save face on the "Wall" with Mexico: As the White House spokesman hinted, Trump may use creative accounting to satisfy his promise that Mexico would pay for the wall. Moreover, if Trump comes out in support of the BAT, it will likely get passed: Chart 11Conservatives Agree With Trump Precedent: President John F. Kennedy's and Jimmy Carter's efforts at tax reform failed because Congress was not supportive, which is not a problem today; whereas Ronald Reagan's personal support for the 1986 tax reform - despite his reservations about the attempt to transform the system and broaden the base - proved critical in helping the bill move through Congress.14 Political science: The political context is a better determinant of presidential success than individual talents, and rising political polarization in the U.S. has created an environment in which "majority presidents," those whose party has a majority in Congress, are even more likely to be successful, while "minority presidents" are more likely to fail on key initiatives. The relevant factors of political context are the party's grip on Congress, the extent of polarization, and, somewhat less significantly, whether the president is in his "honeymoon period" and enjoys public support.15 Of these factors, Trump is only weak on public support, though not among conservatives (Chart 11), who could vote their representatives out of office if they defy Trump on tax reform. The Senate could still cause a serious hang-up. But if Trump and the House GOP stand behind the legislation then Senate Republicans would have to be suicidal to oppose it.16 What about the corporate lobbies that oppose the BAT? Certainly it is highly controversial at home. The tax could hurt import-heavy U.S. businesses and punish citizens with a high propensity to consume - i.e. the poor and elderly, both constituents that make up an important part of Trump's base. But that suggests that there will be carve-outs or phased implementation for key imports like food, fuel, and clothing. Such compromises will be messy, and will mitigate any dollar appreciation and reduce the tax revenues to be gained, but would probably enable the bill to get passed. The opposition of retailers like Wal-Mart and Target is overrated in terms of their power as a lobby. Importers form a slightly larger lobby than exporters, which makes sense given that the U.S. is a net importing economy, but neither of them comprises a large share of total lobbying (Chart 12). The sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart 13). The opposition of the Koch brothers is also overrated, given their unhelpful attitude toward Trump's candidacy for president! Chart 12'Import Lobby' Not A Giant Lobby Chart 13Cuts In Tax Rates Mitigate A New Import Tax Somewhat Bottom Line: The BAT is a radical plan to spur corporate investment and production in the United States, and that goal matches Trump's vision. Trump will be hard pressed to find a more effective, structural way of achieving his goals. And the two-year window with assured GOP control of government will close faster than one might think. Risks To The View A major risk to the BAT is that Trump will fear the repercussions on his political base of higher consumer prices, as hinted above. Consumer pain is a necessary consequence of his mercantilist vision of rebalancing the U.S. from consumption to investment and bringing down the U.S. trade deficit, so Trump will have to decide whether he means what he says. Moreover, if the dollar rises sharply as a result of the BAT, as expected, it would cause pain for the economy and S&P 500 companies, which source 44% of earnings outside the U.S. According to BCA's Global Investment Strategy, the impact of a much stronger dollar on U.S. assets denominated in foreign currencies could amount to a loss worth of 13% of U.S. GDP! (Not to mention Trump's personal wealth from overseas.) Given the huge uncertainties of a totally new tax system, and potential disruption to the economy, it would be perfectly understandable if Trump refused to hitch his fate as president to this wonkish grand experiment. Further, it is not as if there is no alternative to the BAT. Since Republicans will be humiliated if they fail to deliver on tax cuts, Trump's opposition to the BAT would force the House GOP to go back to good ol' fashioned tax cuts without significant revenue raising measures, and specific add-ons to deal with concerns like corporate inversions. Trump would still likely get the repatriation of overseas earnings, a political win, and the economy would experience an increase in investment from tax rate cuts without the uncertain consequences of deeper change. Ronald Reagan's administration offers a precedent for this sequencing, since he began his term with simple tax cuts in 1981 and only later attempted the dramatic tax overhaul of 1986. There is also a risk that the business lobby against the BAT proves stronger than expected and gains traction in the media and popular opinion as a result of the feared consequences on consumer prices. Tax reform is never going to be easy and will always hang in a precarious balance. These are serious risks, but we think Trump and the GOP will move now rather than make any assumptions about their ability to win subsequent elections and enact massive tax reform. The fact that the GOP controls all three branches of government, the BAT plan is well in the making, and Trump is looking to reshape the American economy in ways that align with the BAT, make the odds of passage higher than 50%. Unfortunately, this also means the world should brace for a sharp spike in trade disputes. Bottom Line: There are plenty of reasons to think the BAT plan could collapse of its own weight. The path of least resistance is certainly not the BAT. But we think the preponderance of power in GOP hands in Washington favors radical change, even if it ends up being a policy mistake. Investment Implications: Trade War The WTO is supposed to presume innocence with a country's laws, and it might also approve the BAT on the basis that proponents argue: the U.S. imposing the BAT is not much different from a VAT country increasing its VAT rate while simultaneously slashing the payroll tax (as France has done under President Hollande's administration). This view is misguided. The WTO will rule on the statute and international trade treaties, not the special pleading of the advocates. It may or may not accept that the BAT is equivalent to a VAT; it may or may not object to the wage deduction as a holdover from the "direct" tax on income. The GOP has not yet introduced a draft law, but given the express intention - in the Ryan plan, not even to mention Trump - to put "America first" with a "pro-America approach for global competitiveness," it seems likely that a clash of interests is in the making. In other words, American proponents of the tax are not even hiding its overt protectionist intentions. The WTO will probably discover a subsidy for U.S. exporters and a violation of the principle of trade neutrality with respect to imports. WTO litigation will take years. When the European Union sued the U.S. over its use of Foreign Sales Corporations, a comparable dispute, the proceedings began in 1999 and the WTO ruled against the U.S. in 2002. Ultimately, the U.S. Congress amended the law to avoid retaliation in 2004.17 Trump and the GOP would be less likely to amend their pet project in the current environment, especially if the litigant is the EU at the WTO! Trump, as mentioned, would be inclined to take the fight to the WTO - he has even threatened to withdraw the United States from it. His support group feeds on conflict with supra-national bodies and he may see foreign retaliation as a convenient reason to impose tariffs of his own. The trade environment would deteriorate in the meantime. In 2002, it was assumed that the U.S. and EU could work out an agreement without punitive measures, but that assumption does not hold today. And it would not only be the EU leveling complaints. In short, the U.S. would face foreign retaliation, during the proceedings and likely as a consequence of the WTO ruling. The Trump administration would attempt to mitigate the blowback through a series of bilateral deals, and perhaps the U.S. law would ultimately be modified, but the entire saga would have a negative impact on global trade. Financial markets had many factors to contend with during this period (like the dot-com bubble), and they will similarly respond to large currents in the coming years aside from any BAT. Nevertheless, the tax would reinforce our themes of global multipolarity, mercantilism, and protectionism - and thus reinforce several of our existing trades: We continue to favor small caps over large caps. Small caps are insulated from global trade, will benefit most from the cut in tax rates, and will suffer least from any appreciation of the dollar. Long volatility - Long VIX 20-25 call spread for expiration in March; Long USD versus short EM currencies; Short China-exposed S&P stocks; Short German exporters versus long consumer services. If Trump comes out in opposition to the BAT, he would send a bullish signal for markets in the short term. It would mean, first, that the U.S. will have corporate tax cuts without the broader uncertainties of the BAT; and second, that Trump is actually a pragmatist who eschews radical change if he thinks it will cause too much trouble for U.S. consumers or economic growth. However, it would not necessarily mean that the U.S. would avoid a trade conflict, given Trump's executive powers.18 Of course, the BAT's failure - which is not our baseline - would also be worse for the deficit and debt, as the GOP tax cuts would have no offsetting revenue increases but would rely purely on creative accounting, "dynamic scoring," to appear fiscally acceptable. This legislation would also likely fail to simplify the tax code as much as the BAT would. Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see Alan J. Auerbach, "A Modern Corporate Tax," Center for American Progress, dated December 2010, available at www.americanprogress.org. 3 Please see President's Advisory Panel on Federal Tax Reform, "Final Report," dated November 1, 2005, available at govinfo.library.unt.edu. 4 Please see "A Better Way: Our Vision For A Confident America: Tax," dated June 24, 2016, available at abetterway.speaker.gov. 5 Our colleagues at BCA's Global Investment Strategy have recently provided a very helpful Q&A on the border adjustment tax (BAT), and we would refer readers to that report for a detailed discussion. Please see BCA 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. 6 Please see Reuven S. Avi-Yonah, "Back To 1913?: The Ryan Blueprint And Its Problems," Tax Notes 153: 11 (2016), 1367-47, reprinted by University of Michigan, available at www.repository.law.umich.edu. 7 Amo Houghton, a liberal-leaning Republican from New York, proposed the Taxpayer Protection and IRS Accountability Act of 2002, a bill to streamline IRS administration. It failed in the Republican Congress under President Bush. 8 Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017, available at www.ft.com, and Bob Bryan, "Trump press secretary says the administration is considering a 20% border tax on Mexican imports to help pay for the wall," Business Insider, January 26, 2017, available at www.businessinsider.com. National Economic Council Director Gary Cohn has also indicated that the BAT is an option but not yet decided upon, see CNBC, "Squawk on the Street," February 3, 2017, available at www.cnbc.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 11 The U.S. Ninth Circuit Court of Appeals has already issued a temporary injunction against President Trump's executive orders on immigration. Please see "State of Washington & State of Minnesota v. Trump," available at www.ca9.uscourts.gov. 12 Please see John Lovett, Shaun Bevan, and Frank R. Baumgartner, "Popular Presidents Can Affect Congressional Attention, For A Little While," Policy Studies Journal 43: 1 (2015), 22-44, available at www.unc.edu. 13 Please see BCA Geopolitical Strategy Weekly Reports, "The Trump Doctrine," dated February 1, 2017, and "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 14 Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 15 Jeffrey E. Cohen, Jon R. Bond, and Richard Fleisher, "Placing Presidential-Congressional Relations In Context: A Comparison Of Barack Obama And His Predecessors," Polity 45:1 (2013), 105-126. 16 The Senate Financial Services Committee's support will be critical. Chairman Orrin Hatch has criticized but not yet declared against the BAT. Even if he does, it would not necessarily kill the deal. One of his predecessors, Senator Bob Packwood, initially opposed the Tax Reform Act in 1986 but was ultimately persuaded to support it. If Hatch and the Finance Committee support the initiative, it will pass the Senate. First, the tax overhaul can be accomplished by "reconciliation," a congressional trick that will enable the GOP to avoid a Senate filibuster and pass the tax reform with a simple majority. Second, the Republicans today have almost exactly the proportion of seats in the Senate as the average in previous examples of successful tax reform (see Table 1). So there would have to be a higher share of Republican defectors than in the past to overturn the bill. This is possible but unlikely if Trump and the House GOP are behind the bill. 17 Please see Congressional Research Service, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," dated September 22, 2006, available at digital.library.unt.edu. 18 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com.
Highlights Signing executive orders and memoranda post-Inauguration is a common tactic for new presidents. Unfortunately for investors, political rhetoric has caused uncertainty to surge, while actions affecting profitability have been minimal. The potential for radical changes to trade policy changes should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. Policymakers increasingly believe the economy is operating at full employment. Feature Chart 1Policy Uncertainty Surge It has been a confusing two weeks in Washington. Since taking oath, President Trump has signed eighteen executive orders and presidential memoranda.1 This is not uncommon: Barack Obama signed an equal amount during his first week of his first presidential term, and executive orders are a frequent tactic used by new presidents to quickly deliver on campaign promises. Unfortunately for investors, Trump's signature has not yet found its way to policies that alter the profitability of U.S. businesses and/or clearly lower the risk premium for financial assets (although at the time of writing, there are rumors about an order that will affect Dodd-Frank). Instead, there has been a tremendous amount of rhetoric that has caused political uncertainty to spike higher (Chart 1). We have warned in past weekly reports that it would be difficult for equity prices to sustain gains built on the premise that a new American government will succeed in implementing a pro-business strategy while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders. Actions under the new administration so far support this view. On Trade: Trade is the area of most confusion thus far in the Trump presidency. As our Geopolitical team highlighted in a recent report,2 the new White House seems focused on bringing the U.S. current account deficit down and will attempt to do so by using three primary tools: Protectionism, possibly in the form of a "destination-based border adjustment tax," as discussed in our Special Report two weeks ago.3 Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. and has insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption, though details are scant. Structural Demands: Trump and team appear ready to lob threats at other countries with trade surpluses, such as China - by charging the country with currency manipulation. Note that the above tools are in the White House's toolbox, but are yet to be employed. In terms of concrete action to date, President Trump has signed orders to pull out of the Trans Pacific Partnership (TPP). But this was a non-event since the TPP was never ratified by Congress. Takeaway: The potential for radical changes to trade policy should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. On the flipside, confusing and vague rhetoric should not (yet) form the basis of a negative economic and profit outlook. On Infrastructure: Trump signed an executive order to expedite environmental reviews for high-profile infrastructure projects. This executive order may expedite already approved projects, but any new spending requires approval from Congress. The budget will be announced only in mid- to late- April. Moreover, it is still an open question as to whether Congressional Republicans will try to axe government spending. Senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years! That would amount to a severe fiscal drag, rather than the much hoped-for fiscal thrust expected from infrastructure spending and tax cuts. Takeaway: As we have argued in the past, infrastructure spending could provide a fillip to U.S. growth, but at minimum, investors should not expect that to occur until late 2017 or 2018. On Taxes: None of the executive orders or memoranda directly address taxes. However, a majority of pundits believe that Trump's executive order on January 25 to Build The Wall with Mexico will be funded by U.S. taxpayers. Takeaway: Tax reform requires congressional approval. There has been no step forward as yet for a more market-friendly tax backdrop. On Regulation: On January 30, President Trump signed an executive order stating that for every new regulation proposed, two existing ones would be repealed. On the surface, this seems like excellent news for businesses, especially smaller ones that consistently argue that "red tape" is a major problem for their companies (Chart 2). After all, the U.S. ranks very poorly among global peers on how easy it is to start a business (Table 1). Note that the World Bank assigns the U.S. a much higher overall score for ease of doing business (8th), but this is due to high scores in only two areas: access to credit and bankruptcy protection laws! Chart 2(Part II) Regulation Is A Problem Table 1(Part I) Regulation Is A Problem Unfortunately, the language of the executive order is sufficiently vague that it is not clear what impact there will actually be. First, it is impossible to know which agencies and branches of government the order applies to. Second, it is not clear that a President has the legal authority to mandate the number of regulations, i.e. this executive order may be impossible to uphold. The President also signed a memorandum to streamline and reduce the regulatory burden for manufacturers. Though there is no immediate impact on businesses, the memorandum opens a 60 day window for the secretary of commerce to consult stakeholders. Takeaway: The President is serious about deregulation, but if anything, the 2-for-1 regulation order only serves to underscore that unwinding the regulatory burden is a complicated process that is unlikely to be achieved in the first 100 days of office. The bottom line is that the new administration has been busy, but little of their work thus far has been of direct concern to financial markets and underlying profitability. Instead, policy uncertainty has risen: protectionism, de-regulation and tax reform are all high on their agenda, but details are scant. This has left investors with little visibility. Our view is that the underpinnings of a self-reinforcing recovery are in place and thus will fuel outperformance of stocks relative to bonds on an intermediate time horizon (see last week's Special Report and also below).4 However, the rise in policy uncertainty serves to solidify our conviction that at current prices, risk assets are vulnerable to a near-term correction. Indeed, although not uniformly bearish, equity technical readings are beginning to herald a more treacherous phase ahead. Equity Technicals: Mixed Messages We are monitoring technical indicators for warning of a near-term equity pullback within the context of a longer term bull market. So far, the message is mixed. For example, our composite technical indicator is in the middle of its range and is not heralding danger. However, sentiment readings are at a bullish extreme. Our composite sentiment indicator remains near historic highs, which tends to be a good contrarian indicator (Chart 3). Meanwhile, the number of stocks above their 30 week and 10 week averages has also shot higher. Importantly, insiders are taking advantage of the price rally to sell their stock. The insider sell/buy ratio has soared to levels that typically herald corrections. Somewhat curiously, the VIX index - a measure of the cost of insurance - remains at bargain basement levels. This suggests that investors may be complacent to a near-term correction. Overall, sentiment readings have become extreme as has price momentum. As highlighted above, we expect that the near term catalyst for a pullback will likely center around policy disappointment. A more encouraging intermediate term outlook is supported by stronger economic fundamentals and, at least for now, a go-slow Fed. Fed & Economy Last week's FOMC policy statement included only minor tweaks from the previous one. Policymakers were silent as to how they view the impact on growth and inflation from the new Administration. Data released since the December minutes - when it appeared that the committee was shifting to a less dovish stance - have supported the Fed's more optimistic outlook. For example, the ISM manufacturing is trending higher, while the non-manufacturing index continues to be strong (Chart 4). On the manufacturing side, the composite index rose again in January, as the sector recovers from an energy-led recession. New orders held onto earlier impressive gains. The new orders-to-inventories ratio ticked down, but remains elevated, suggesting that there is more upside for industrial production in the coming months. Chart 3Equity Technicals: Mixed Message Chart 4Positive Economic Momentum In addition, as highlighted in our January 16 Weekly Report, conditions are ripe for a rebound in consumer spending.5 As confidence in the employment backdrop rises, the likelihood for a lower savings rate improves. Indeed, the January employment report, released on Friday, surprised to the upside, as non-farm payrolls grew by 227 000 (Chart 5). Despite the strong payrolls growth, the unemployment rate ticked higher to 4.8% due to an increase in the participation rate and average hourly earnings increased by a meager 0.1% m/m. Still, we expect that wages will rise as the labor market steadily tightens and Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. To this end, more policymakers are making the case that the economy is at full employment. In a speech in mid-January, San Francisco Fed president Williams argued that the economy has achieved full employment and that the economy only needs to create about 80 000 jobs to keep up with labor force growth.6 The implication is that with an average monthly payroll of 180 000, job creation will quickly put downward pressure on the unemployment rate. The San Francisco Fed has introduced a new, "Non Employment Index"7 which attempts to correct for the structural decline in participation (Chart 6). To construct the index, researchers treat everybody in the population as potentially in the labor force and construct a broader unemployment rate-a "non-employment index." This measure incorporates the unemployed and nonparticipants alike, based on their respective tendency to find jobs. They argue that when one carefully accounts for the availability of nonparticipants this way, the resulting broad non-employment index is consistent with a labor market at full strength. As the top panel of Chart 6 shows, even accounting for participation in this way, the non-employment index gives a very similar message to the standard unemployment rate. Chart 5Solid Employment Fundamentals Chart 6Full Employment = Wage Pressures The bond market is currently priced for two rate hikes later this year. We agree with this assessment, though view any surprises to the upside. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The latter have less legal weight than an executive order but serve as guidelines for the priorities of government. 2 Please see BCA Geopolitical Strategy Weekly Report "The 'What Can You Do For Me' World?," dated January 25, 2017, available at gps.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 23, 2017, available at usis.bcaresearch.com 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017, available at usis.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report "U.S. Consumer: The Comeback Kid," dated January 16, 2017, available at usis.bcaresearch.com 6 http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/january/looking-back-looking-ahead economic-forecast/?utm_source=frbsf-home-president-speeches&utm_medium=frbsf&utm_campaign=president-speeches 7 https://www.richmondfed.org/research/national_economy/non_employment_index
Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights U.S. growth will remain firm over the next 12 months, but then will begin to slow from its above-trend pace as the economy runs out of spare capacity. Fiscal stimulus, by the time it is enacted, may simply end up pushing up wages, interest rates, and the dollar, rather than boosting corporate profits. While the U.S. is not at an imminent risk of a recession, the historic record suggests that recessions are more likely to occur when an economy has achieved full employment. Equity investors should favor Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are reasonably favorable. Feature The Rusty Lining The U.S. economy is approaching full employment. The headline unemployment rate has fallen to 4.7%, close to most estimates of NAIRU. Broader measures of labor market slack, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 1). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are near 2007 levels (Chart 2). Chart 1U.S. Labor Market: Not Much Slack Left Chart 2Most Labor Market Survey Measures ##br## Now Consistent With Full Employment It is obviously good news that most people in the U.S. who want to work are able to find jobs. However, at the risk of sounding like spoilsports, we see three risks associated with this development. First, and most obviously, the fact that the U.S. economy is close to full employment means that it will not be able to grow at an above-trend pace for much longer. Second, efforts by the Trump administration to lift aggregate demand with fiscal stimulus may prove to be counterproductive: Rather than boosting GDP growth, the stimulus may simply lead to higher wage inflation and a stronger dollar. This could hurt corporate profits. Third, there is compelling evidence that the risks of a recession rise as an economy approaches full employment and begins to overheat. We discuss all three issues in turn. Weak Supply Will Limit Growth One of the more striking aspects of the U.S. economic recovery is that the output gap - the difference between what an economy is capable of producing and what it actually is producing - has nearly disappeared even though GDP growth has been rather lackluster. This has occurred for one simple reason: Potential GDP growth has been extremely weak. Chart 3 shows that the slowdown in potential GDP growth has been a global phenomenon. In every major economy, the output gap would be larger today than in 2008 if potential GDP had grown at the rate that the IMF forecasted back then. Chart 3AWeak Supply Growth Has Narrowed Output Gaps Chart 3BWeak Supply Growth Has Narrowed Output Gaps Many commentators are hopeful that the combination of sizeable tax cuts and President Trump's pledge to reduce red tape will lead to a marked acceleration in potential U.S. GDP growth. There is some validity to this view. Statutory corporate tax rates in the U.S. are among the highest in the OECD, while the Code of Federal Regulations is 178,000 pages long, eight times the size that it was in 1960 (Chart 4). Still, we are skeptical that the economic benefits of slashing corporate taxes and cutting red tape would be as great as some pundits are touting. If one includes the various loopholes and deductions that companies can avail themselves of, effective corporate tax rates in the U.S. are not particularly high compared with those of other countries.1 Cutting corporate taxes may also do precious little to lift investment spending, given that U.S. companies are already flush with cash and have access to plenty of cheap financing. While the regulatory burden on U.S. businesses has increased somewhat over the past seven years, it is still quite low compared to other major economies according to the World Bank's Doing Business report (Chart 5). And many of the regulations that businesses routinely complain about serve a useful purpose, particularly in the areas of health, clean air and water, and financial stability. Consistent with the analysis above, there is little evidence that Reagan's tax cuts and deregulation initiatives had much effect on productivity growth in the 1980s (Chart 6). Meanwhile, Trump's efforts to crack down on illegal immigration will reduce labor force growth, curbing potential GDP growth in the process. Trade protectionism will also dent productivity in some sectors of the economy. The bottom line is that potential growth is unlikely to rise much above 2% for the foreseeable future. Chart 4There Are Prolific Writers In The U.S. Administration Chart 5Regulatory Burden In The U.S. Is Relatively Low Chart 6The Reagan Years Were No Boon For U.S. Productivity Flagging Fiscal Multipliers As we discussed last week, market participants may be overestimating the extent to which fiscal policy will be eased over the next two years.2 Suppose, however, that the optimists are right; suppose Donald Trump is able to fully deliver on his campaign pledge to raise infrastructure spending and slash taxes. Let us also suppose that, contrary to our expectations, lower personal and corporate tax rates do prompt households to significantly boost spending, while incentivizing firms to increase capital expenditures. What then? The answer is that this still may not translate into significantly faster economic growth. The reason is straightforward: When the output gap is small, an increase in aggregate demand will largely translate into higher inflation rather than increased output. An overheated economy, in turn, will drive up real interest rates, leading to less spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, swelling imports and reducing exports. This "crowding out" effect will reduce the net effect of fiscal stimulus on growth. The empirical evidence bears this out. Table 1 shows the fiscal multipliers are much smaller when an economy is close to full employment. Table 1The Effect Of A $1 Increase In Fiscal Spending On Aggregate Demand The implication is that Trump's fiscal stimulus plan, by the time it is enacted, may simply end up lifting interest rates, the dollar, and wages, without delivering much acceleration in real business sales. Again, this is not just a theoretical possibility. Chart 7 shows that the ratio of corporate profits-to-GDP has tended to decline when the unemployment rate has fallen below its full employment level. This suggests that the re-acceleration in earnings growth that began last summer could run out of steam later this year. Chart 7The Effects Of Full Employment Recession Risks Are Slowly Rising Business cycle recoveries may not die of old age. However, as anyone who's been around long enough knows, old age isn't exactly conducive to good health either. Chart 8 shows that there is a positive correlation between the degree of labor market slack and the length of time until the next recession. This implies that recessions are more likely to occur when an economy approaches full employment. In fact, outside of the 1982 recession, which in many respects was just a continuation of the 1980 recession, there has never been a case in the post-war era where a recession began at a time when the unemployment rate was above its full employment level. Formal econometric analysis bears this out: According to our calculations, the U.S. has had nearly a 31% chance of falling into recession over the subsequent 12-month period when the economy was at or above full employment, compared with only an 8% chance at all other times.3 Part of the relationship between economic slack and recession risk can be explained by the fact that the unemployment rate is mean reverting. Thus, when the unemployment rate is very low, it is more likely to go up than down. And history suggests that even a slight rise in the unemployment rate is a powerful harbinger of recession. In fact, Chart 9 shows that there has never been a case where the unemployment rate has risen more than one third of a percentage point without the U.S. falling into a recession. Chart 8U.S.: A Tighter Labor Market Means We Are Getting Closer To The Next Recession Chart 9Even A Small Increase In The Unemployment Rate Warns Of A Recession When Animal Spirits Bite Back Mean reversion, however, is only part of the story. As Hyman Minsky famously noted, stability begets instability. By this, he meant that good economic times tend to encourage excessive risk taking, and this sows the seeds of a future crisis. The good news is that the U.S. does not currently suffer from any major economic imbalances. Perhaps it was the severity of the crisis; perhaps it was the lackluster recovery; but whatever the reason, animal spirits have been slow to return this time around. Sure, stocks have soared thanks to ultra-low interest rates, but both business and residential investment remain subdued (Chart 10). Nevertheless, signs of excess are starting to appear in places. Corporations may have been restrained in their capital spending plans, but that did not stop them from piling on new debt to finance share buybacks, and mergers and acquisitions (Chart 11). As a result, our Corporate Health Monitor has been in deteriorating territory since the second half of 2013 (Chart 12). Chart 10Business And Residential Investment Remain Subdued Chart 11Companies Have Been Piling On New Debt Chart 12U.S. Corporate Health Keeps Deteriorating Policy risks have also increased. These include the possibility of a global trade war, rising support for anti-establishment parties in Europe, and a pronounced slowdown in China that precipitates mass capital flight and a sharp depreciation of the RMB. Complicating matters is the fact that policy rates remain quite low across all major economies, which limits the ability of central banks to respond to another economic downturn. Investment Conclusions Chart 13More Optimism About The ##br##Longevity Of The Business Cycle Fears of secular stagnation, which were all the rage just 12 months ago, have given way to unbridled confidence about the future. Investors now dismiss the exact same things they once feared from Donald Trump, even though Trump the President has proven to be little different from Trump the Candidate. Among participants in the New York Fed's Survey of Primary Dealers who assign a non-zero probability that rates will fall back to zero at some point over the next three years, the median respondent expects that it would take 27 months to reach this sorry state of affairs, up from 11 months in April 2016 (Chart 13).4 If one uses this as proxy for when investors believe the next recession will roll around, it implies that market participants now believe that the recovery will last more than twice as long as they thought last summer. We agree that U.S. growth is likely to remain firm over the next 12 months. As we argued last October in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the U.S. economy has a lot of momentum behind it.5 As such, we continue to expect Treasury yields to rise and the dollar to appreciate over the next 12 months. Nevertheless, we are cognizant that much can go wrong with this assessment. Chart 14 shows that most of the recent better-than-expected data has been confined to survey measures of economic activity - what economists call "soft data." The so-called "hard data" has been mediocre. This is not a major red flag, as the hard data often lags the survey results, but it does underscore the fragile nature of the recovery. Chart 14Survey Measures Have Improved More Than The Hard Data All this puts U.S. stocks in a difficult position. If growth does end up disappointing, equities will suffer. However, if growth remains strong, bond yields are likely to rise further, taking the dollar up with them. Meanwhile, a tight labor market will increasingly put upward pressure on real wages, hurting corporate profit margins in the process. With that in mind, investors should overweight equity markets in Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are more favorable. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 According to a report by the Congressional Research Service, the U.S. statutory corporate tax rate was 39.2% while the GDP-weighted average rate in the OECD excluding the U.S. was 29.6% (based on 2010 data). Meanwhile, the U.S. effective tax stood at 27.1% versus the 27.7% average of its OECD peers (based on 2008 data). Studies conducted before the Great Recession also show that the U.S. effective rate is about the same as the GDP-weighted average rate of other major countries. For further details, please see Jane G. Gravelle, "International Corporate Tax Rate Comparisons and Policy Implications," Congressional Research Service (January 6, 2014). 2 Please see Global Investment Strategy Weekly Report, "Two Speed Bumps For The Global Reflation Trade," dated January 27, 2017, available at gis.bcaresearch.com. 3 The probability of a U.S. recession occurring within the next 12 months is calculated by employing a simple logistic model using data from 1960 to the present. The dependent variable (Y) is assigned the value "1" during months when a recession occurs over the subsequent 12-month period, or "0" otherwise. An independent variable (X) is assigned the value "1" when the economy is at full employment, or "0" otherwise. Assuming full employment is reached when the unemployment rate is at least 25 bps lower than the non-accelerating inflation rate of unemployment, the resulting probabilities for a recession within the next year are as follows: P(Y=1 given that X=1) = 31%; P(Y=1 given that X=0) = 8%; P(Y=1 given that X=1 or given that X=0) = 17%. In a nutshell, the probability of a recession occurring increases by 23 percentage points (from 8% to 31%) once full employment is reached. 4 In both the April 2016 and December 2016 surveys, all but one respondent indicated that there was a non-zero chance that rates will fall to zero over the relevant forecast horizon. 5 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017
Highlights Duration: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). Economy: U.S. GDP growth will be solidly above trend in 2017, driven in large part by accelerating consumer spending. Feature The divergence in economic growth between the U.S. and the rest of the world has been one of our key investment themes for much of the past two years. All else equal, the greater the divergence in growth between the U.S. and the rest of the world, the more the U.S. dollar comes under upward pressure. A strengthening dollar limits how far the Fed can lift rates and caps the upside in long-dated yields. In fact, in a report published last October titled "Dollar Watching: An Update"1 we wrote: Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product until a December rate hike has been fully discounted by the market. Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. With the December rate hike now in the rearview mirror, global growth divergences do not appear to be a strong headwind for bond yields. In fact, the trade-weighted dollar has flattened off since the Fed lifted rates and bullish sentiment toward the dollar has plunged even though rate hike expectations remain elevated (Chart 1). This suggests that the dollar is so far not having much of an impact on the U.S. growth outlook or the expected path of monetary policy. Digging a little deeper, it appears we are witnessing a synchronized upturn in global growth led by the manufacturing sector (Chart 2). The Global Manufacturing PMI is in a clear uptrend, while the diffusion index suggests the improvement is broad based. Similarly, our Global Leading Economic Indicator is once again expanding, while its diffusion index is holding steady above the 50% line. Chart 1Dollar Sentiment: A Key Indicator Chart 2Synchronized Global Recovery Although the extremely high level of economic policy uncertainty increases the odds of a near-term selloff in risk assets and related flight-to-quality into Treasury securities, the strength of the global growth impulse and sustainability of the U.S. economic recovery (see section titled "U.S. Economy: A Healthy Consumer Leads The Way" below) means we would view any risk-off episode as an opportunity to reduce portfolio duration and increase exposure to spread product. As such, given our 6-12 month investment horizon and the inherent difficulty in forecasting near-term market riot points, this week we begin the process of shifting our portfolio in this direction. Specifically, we move from an "At Benchmark" back to a "Below Benchmark" duration stance and we also upgrade spread product from neutral (3 out of 5) to overweight (4 out of 5), while downgrading Treasuries from neutral (3 out of 5) to underweight (2 out of 5). Within spread product we upgrade investment grade corporates from neutral (3 out of 5) to overweight (4 out of 5) and upgrade high-yield from underweight (2 out of 5) to neutral (3 out of 5). We expand on the rationale for each move below. Portfolio Duration Chart 3Treasuries Now Expensive Two weeks ago,2 we detailed our bearish 6-12 month outlook for U.S. bonds, while also pointing to three factors that had so far prevented us from adopting a below-benchmark duration stance. The three factors were: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation Two weeks ago the 10-year Treasury yield was trading 9 basis points cheap on our 2-factor model based on Global PMI and bullish dollar sentiment. Since then, bullish sentiment has declined and Flash3 PMI readings from the U.S., Eurozone and Japan were all strong. If we assume that final PMIs from these regions are in line with the Flash numbers and that the PMIs from all other countries remain flat, then we calculate that the 10-year Treasury yield is actually 4 basis points expensive relative to fair value (Chart 3). In short, valuation argues even more in favor of reducing portfolio duration than it did two weeks ago. Factor 2: Uncertainty Economic policy uncertainty remains elevated and, unusually, has de-coupled from surveys of consumer and business confidence (Chart 4). Certainly, there is a risk that confidence measures relapse in the near-term if it appears as though some of the new President's promises related to tax cuts and deregulation will not be delivered. However, this risk needs to be weighed against the bond-bearish combination of protectionism and fiscal stimulus favored by the new administration, especially at a time when the economy is close to full employment. Factor 3: Sentiment & Positioning Bond sentiment and positioning remain decidedly bearish according to our Bond Sentiment Indicator and net speculative positioning in Treasury futures, although the J.P. Morgan client survey shows that clients' duration positioning is close to neutral (Chart 5). It is likely that some further capitulation of short positions is necessary before Treasury yields can move decisively higher. However, these shifts in positioning can occur very quickly and given the reading from our valuation model we feel that now is the appropriate time to reduce duration exposure. Chart 4Elevated Uncertainty Remains A Near-Term Risk... Chart 5...As Does Bearish Positioning Bottom Line: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product In last week's report,4 we explored the performance of spread product throughout the four phases of the Fed cycle (Chart 6), which are defined as follows: Chart 6Stylized Fed Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Based on the fact that core PCE inflation remains below the Fed's target and the view that its uptrend will proceed only gradually, we concluded that we are presently in Phase I of the Fed cycle and would probably remain there for the balance of the year. Historically, spread product has performed well in Phase I of the Fed cycle, with only Phase IV producing higher average monthly excess returns. However, the Fed cycle is only part of the story. Our Corporate Health Monitor (CHM) - a composite measure of balance sheet health for the nonfinancial corporate sector - has been in "deteriorating health" territory since late 2013. Historically, this measure has an excellent track record of flagging periods of spread widening (Chart 7). Chart 7The Corporate Health Monitor And Credit Spreads To augment our analysis, this week we re-examine average monthly excess returns for investment grade corporate bonds in the four phases of the Fed cycle but this time we also split each phase into periods of improving and deteriorating corporate health (Table 1). Table 1Investment Grade Corporate Bond Excess Returns* Given Reading From ##br##BCA Corporate Health Monitor And The Phase Of The Fed Cycle (July 1989 To Present) Table 1 shows there have been 14 months since 1989 when Phase I of the Fed cycle coincided with deteriorating corporate health, according to the CHM. Conversely, Phase I of the Fed cycle coincided with improving corporate health in 25 months. However, 13 of the 14 months when Phase I of the Fed cycle coincided with deteriorating corporate health are the most recent 13 months. In other words, the current combination of tightening (but still-supportive) monetary policy and weak corporate balance sheets is unprecedented. The other factor we have not yet considered is valuation, as measured by the starting level of corporate spreads. In Table 2 we present average monthly excess returns for investment grade corporate bonds split by both the phase of the Fed cycle and the investment grade corporate option-adjusted spread. At present, the average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is 120 bps. Table 2Investment Grade Corporate Bond Excess Returns* Given Previous Month Option-Adjusted Spread** ##br##And The Phase Of The Fed Cycle (July 1989 To Present) In Table 2 we observe that usually spreads are much lower in Phase I of the Fed cycle, typically between 50 bps and 100 bps, and that periods when spreads are above 100 bps generally coincide with higher excess returns. However, we must also recall that corporate health is typically still improving in Phase I of the Fed cycle, so today's higher spread levels might be justified by worse credit quality. Chart 8Value Is Stretched In Junk It goes without saying that the unusual combination of deteriorating corporate health and still-supportive Fed policy is a complicated environment for credit investors to navigate. Our view is that accommodative Fed policy will prevent material spread widening, at least until inflation breaks above the Fed's target and we shift into Phase II of the Fed cycle, but it is also probably not reasonable to expect spreads to tighten much further from current levels. We are looking for low, but positive, excess returns from spread product, consistent with the available carry. Bottom Line: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade our allocation to high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). We retain only a neutral allocation to high-yield due to the longer-run risks posed by poor corporate health, and tight valuations for high-yield bonds (Chart 8). U.S. Economy: A Healthy Consumer Leads The Way U.S. GDP growth decelerated to 1.9% in Q4 from 3.5% in Q3. Growth in consumer spending slowed to 2.5% from 3.0%, while fixed investment spending picked up to 4.2% from 0.1%. The headline 1.9% GDP print also includes a -1.7% contribution from net exports and +1.0% contribution from inventories. Taking a step back from the quarterly data, we see that the growth in real final sales to domestic purchasers - a measure of growth that strips out the volatile trade and inventory components - has clearly shifted into a higher range during the past couple of years (Chart 9). Further, leading indicators for each individual component of growth all suggest that further acceleration is in store (Chart 10). Chart 9Growth Finds A Higher Gear Chart 10Contributions To GDP Growth But crucially, it is the fundamental drivers underpinning the outlook for consumer spending that lead us to believe that U.S. economic growth will maintain an above-trend pace throughout 2017. As was observed by our U.S. Investment Strategy service in a recent report,5 income growth - the main driver of consumption trends - appears poised to accelerate, driven by accelerating wage growth that is starting to kick in now that the economy has finally reached full employment (Chart 11). The boost in consumer confidence could also lead to a lower savings rate, further increasing the impact on spending (Chart 11, bottom panel). Chart 11Consumer Spending = Income + Confidence Bottom Line: A healthy consumer is the back bone of the U.S. economy, and elevated consumer demand will also lend support to corporate fixed investment and the housing market. We expect that U.S. growth will be solidly above trend in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, titled "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 3 The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data. 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification