Developed Countries
Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.
Overweight Last week saw some sad news as Hunter Harrison, the CEO of CSX and legendary railroad captain, passed away. While we are overweight the S&P railroads index, we did not upgrade when Mr. Harrison joined CSX and we will not change our rating as a result of his passing. Rather, we continue to focus on surging global trade volume (second panel) as the fundamental revenue driver. Our rail shipment commodity group diffusion indicator is sending a nearly unanimous message of rising volumes (third panel), which should correlate with continued overall industry volume gains. Further, industry pricing power is soaring while employment is declining (bottom panel) which, in conjunction with the previously noted volume growth, implies solid productivity improvements to come. This means margins have a powerful tailwind, irrespective of the operating leverage that topline growth should deliver. In sum, railroads remain a core industrial and transports holding; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.
In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3% and we think the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. The Fed and other G7 central banks are simultaneously tightening monetary policy, either through rate hikes or reduced asset purchases or a combination thereof. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (second panel). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners as global oil majors have returned to profitability in the new era of $50/bbl oil, suggesting that the worst is behind the industry. Notwithstanding the still-supportive context, this was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Should a broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now; see Monday's Weekly Report for more details.
This will be the last U.S. Bond Strategy report of the year. The next publication will be on January 9 with our Portfolio Allocation Summary for January 2018. Until then we extend our best wishes for a wonderful holiday and a Happy New Year. Highlights Duration: Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. Yield Curve: The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Feature Chart 1Fed Sees Stronger Growth In 2018 As was widely anticipated, the Fed delivered the fifth rate hike of the cycle last week, bringing the target range for the fed funds rate up to 1.25% to 1.5%. What's more, neither the Summary of Economic Projections nor Janet Yellen's final post-meeting press conference gave much indication that the Fed is worried enough about inflation to deviate from its current pace of tightening. To wit, the Fed did not alter its median projections for inflation or the near-term pace of rate hikes. As in September, the Fed still expects core PCE inflation to rise from its current 1.45% to 1.9% by the end of 2018. It also still expects to lift rates three more times next year. However, the Fed did respond to recent strong growth and employment data by revising its projection for GDP growth higher and its projection for the unemployment rate lower (Chart 1). It also revised the post-meeting statement to indicate that it now believes the economy has reached full employment. In other words, the Fed believes there is no longer any slack in the labor market. This dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 2 shows that Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995 (Chart 2, panel 2). It is this deviation that prompted Chair Yellen to say the following at last week's press conference: [W]e've had an undershoot of inflation for a number of years. We absolutely recognize that. I think until this year [the] undershoot was understandable. In other words, until this year the Fed's model did a good job of explaining low inflation. But now that a large residual has opened up between inflation and the Fed's model, it is reasonable for both the market and the Fed to question whether the underlying relationship between inflation and economic growth has changed. The market has already rendered its verdict in the affirmative. The compensation for inflation priced into the 10-year Treasury yield is only 1.88%. Historically, a level between 2.4% and 2.5% suggests the market has faith in the Fed's 2% inflation target. Further, the yield curve has been flattening dramatically. The 2/10 Treasury slope is down to 51 bps, and the fed funds/10-year slope is down to 94 bps. In other words, the bond market is discounting that the Fed can only deliver another 3-4 rate hikes before the economy starts to struggle, at which point inflation will still be below target. The recent revisions to the Fed's own economic projections also suggest that the perceived relationship between economic growth and inflation has weakened. The Fed revised its projection for GDP growth higher and its projection for the unemployment rate lower, but left its projections for inflation and the fed funds rate unchanged. This can only mean that the Fed views the relationship between economic growth and inflation as having weakened since September. So how much longer can the Powell Fed tighten policy without inflation actually trending higher? This is the single biggest question for bond markets and we detailed the three possible answers in last week's report.2 The most likely scenario is that the Fed's Phillips Curve model starts to work again next year. Core inflation trends higher and this eases the flattening pressure on the yield curve allowing the Fed to continue tightening. In support of this outcome, pipeline inflation measures have hooked up in recent weeks, suggesting that core inflation is about to bottom (Chart 3). Chart 2The Fed's Inflation Model Chart 3Pipeline Inflation Measures However, in the scenario where inflation does not move higher, the next most likely outcome is that risk assets sell off in the next couple months. This would lead to a tightening of financial conditions and would cause the Fed to react by adopting a more dovish policy stance. We showed in last week's report that risk off episodes in junk spreads become more frequent once the 2/10 Treasury slope breaks below 50 bps. It is also possible that the Fed proactively adopts a more dovish policy stance without having its hand forced by tighter financial conditions, but this now seems like the least likely outcome. Implications For Treasury Yields In the most likely scenario where core inflation trends higher during the next six months, Treasury yields will rise driven mostly by the inflation component (Chart 4). A return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate would put between 52 bps and 62 bps of upward pressure on the nominal 10-year Treasury yield. This means that even if the real 10-year yield remains flat we should see the nominal 10-year yield in a range between 2.87% and 2.97% by the time that core inflation gets back to the Fed's target. But even a flat real 10-year yield seems like a fairly conservative assumption. We can think of the real 10-year yield as being driven by three main factors: (i) the fed funds rate itself, (ii) expectations for future changes in the fed funds rate and (iii) a term premium. In Chart 5 we show that a simple model based on these three factors does a good job explaining the fluctuations in the real 10-year Treasury yield.3 Chart 4Market Not Priced For Rising Inflation Chart 5A Simple Model Of The Real 10-Year Treasury Yield The model works better prior to the Great Recession because we deliberately chose pre-crisis coefficients for our three independent variables. Chart 6 shows the coefficients for the three variables estimated over rolling 5-year intervals, and the dashed horizontal lines show the coefficients we chose for our model. It is clear from Chart 6 that the zero-lower bound caused the estimated coefficient on the fed funds rate to decrease and the estimated coefficient on the 12-month discounter to increase. We expect both will converge slowly back toward pre-crisis levels now that the fed funds rate is well off the zero bound. Chart 6Controlling For The Zero Lower Bound The key conclusion from this modeling exercise is that, even with fairly conservative assumptions, it is difficult to craft a reasonable scenario where the real 10-year Treasury yield declines during the next 12 months. The forecast in Chart 5 assumes that the Fed lifts rates three times next year - consistent with its median projections - but also that rate hike expectations fall so that by the end of 2018 the market only expects one further rate hike during the next 12 months. Finally, we assume that implied interest rate volatility stays flat at historically low levels. Even in that relatively benign scenario our model suggests that the real 10-year Treasury yield would drift higher during the next 12 months. This leads us to project a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation moves back close to the Fed's 2% target. Implications For The Yield Curve The slope of the yield curve during the next 6-12 months will depend both on how quickly core inflation rises and how quickly the Fed tightens policy. Table 1 shows different scenarios for the fed funds rate, the 2-year/fed funds slope - which can be thought of as the expected number of rate hikes during the next two years - and the 10-year Treasury yield. For example, if core inflation rises back close to the Fed's target by next June and the Fed has only delivered one or two more rate hikes during that time period, then it is very likely that the yield curve will have steepened, at least modestly. If the Fed gets three or four hikes off before inflation gets back to target, then it is much more likely that the yield curve will have flattened. We think a modest curve steepening is the most likely outcome for the next six months. This is premised on the view that core inflation will start to trend higher in the coming months, and will approach the Fed's target by the middle of next year. During that timeframe the Fed will only deliver one or two rate hikes, consistent with its median projection for three hikes in 2018. Once core inflation is back closer to target and the compensation for inflation priced into long-dated Treasury yields is back to its pre-crisis 2.4% to 2.5% range, then aggressive curve flattening becomes much more likely. Table 1Scenarios For The Number Of Fed Rate Hikes By The Time That Inflation Returns To Target Bottom Line: The Fed is playing a dangerous game by continuing to signal a gradual pace of rate hikes in the face of inflation data that have not kept pace with its projections. Ultimately we think the Fed's models will be proven correct during the next six months and core inflation will resume its gradual cyclical uptrend. Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle Update: Favorable For Now, But Will Turn In 2018 The U.S. Financial Accounts (formerly Flow of Funds) were released this month. This gives us the opportunity to update our Corporate Health Monitor (CHM), as well as our other indicators of non-financial corporate sector leverage. Recall that historically three conditions must be met before the credit cycle turns and a sustained period of corporate spread widening kicks in. They are: Corporate balance sheet health must be deteriorating Monetary policy must be restrictive Bank lending standards must be tightening Chart 7 provides a snapshot of the current state of affairs for these three criteria. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Corporate Balance Sheet Health The CHM is our number one indicator of non-financial corporate sector balance sheet health (Chart 7, panel 2). It has been signaling "deteriorating health" since 2015, but ticked down in the third quarter and has been moving slowly back toward "improving health" territory since the beginning of the year. It is worth mentioning that in order to get a leading signal from our CHM we use de-trended versions of the Monitor's underlying components. The six financial ratios that we combine to calculate the CHM are shown in their not de-trended forms in Chart 8. We also show a not de-trended version of the overall Monitor in the second panel of Chart 7. Notice that while the traditional (de-trended) CHM has been signaling "deteriorating corporate health" since 2015, the not de-trended version remains in "improving health" territory. Box: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets The unusual length of the current recovery has caused the not de-trended and de-trended versions of the CHM to diverge by much more than in prior cycles. While this almost certainly means that the negative signal from our traditional (de-trended) Monitor came too early this cycle, we should also expect the negative signal from the not de-trended version of our model to arrive too late. So while the truth lies somewhere in between the de-trended and not de-trended versions, we are fairly confident in saying that the condition of "deteriorating corporate health" has already been met for this cycle. Restrictive Monetary Policy Panels 3 and 4 of Chart 7 show two different indicators for the stance of monetary policy. The first is the real effective fed funds rate relative to the Laubach-Williams (2003) estimate of its equilibrium level. According to this measure, monetary policy moved into restrictive territory following last week's rate hike. However, a much simpler indicator for the stance of monetary policy is the slope of the yield curve. While the slope of the yield curve is not flashing red just yet, it has been rapidly flattening and is approaching levels that signaled a restrictive stance of monetary policy in prior cycles. In last week's report we showed that monthly excess returns to high-yield bonds have averaged only 12 bps when the slope of the 2/10 Treasury curve is between 0 bps and 50 bps, and that monthly excess returns have been negative 48% of the time in those periods.4 Tightening Bank Lending Standards The Federal Reserve's most recent Senior Loan Officer Survey showed that banks continue to modestly ease standards on commercial & industrial (C&I) loans (Chart 7, bottom panel). We traditionally view this third condition as more of a confirming indicator of the turn in the credit cycle. That is, tighter bank lending standards are typically preceded by deteriorating corporate health and restrictive monetary policy. An Additional Measure Of Corporate Sector Leverage In addition to the components of our CHM, we also track a measure of gross leverage for the non-financial corporate sector, calculated as total debt divided by EBITD (Chart 9). Historically, the trend in corporate bond spreads has followed the trend in gross leverage, or at the very least, deviations in direction between spreads and leverage have tended not to last very long. Chart 9Rising Gross Leverage Is A Risk For Spreads Our measure of gross leverage ticked higher in Q3, EBITD grew at an annualized rate of 4.1% but this was not enough to offset the 5.4% annualized increase in corporate debt. Overall, gross leverage has been roughly flat this year even though corporate spreads have tightened. Going forward, our leading indicators are still consistent with mid-single digit profit growth. If that view pans out then the pace of debt accumulation will need to fall in order for leverage to decline. We will be watching this measure of leverage closely during the next couple of quarters, if leverage continues to increase then we will be quicker to call the end of the credit cycle. Bottom Line: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The Phillips Curve model of inflation shown in Chart 2 is re-created from Janet Yellen's September 2015 speech: https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 3 We use our 12-month fed funds discounter to measure rate hike expectations and the MOVE implied volatility index as a proxy for the term premium. 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights 2018 Model Bond Portfolio Positioning: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Country Allocations: Divergences in likely central bank policy moves in 2018 will lead to more cross-country bond market investment opportunities. In our model portfolio, we are maintaining underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and adding small overweights in the U.K. and Australia (where rate hikes are unlikely). Spread Product: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Feature Two weeks ago, we published our "Key Views" report, outlining the main fixed income investment implications deriving from the 2018 BCA Outlook.1 In this, our final report of 2017, we translate those Key Views into direct allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. As we always remind our clients, our model portfolio is intended as a vehicle to communicate our opinions on the relative attractiveness and trade-offs between fixed income countries and sectors. That is to say, the portfolio not only includes our traditional individual country and sector recommendations, but attaches actual weightings to those views within a fully invested hypothetical bond portfolio. The main takeaway from our Key Views is that bond market performance, and ideal asset allocation, is likely to look very different as the year progresses (Table 1). The first half of the year will see continued strong global growth and slowly rising inflation, but with central banks only slowing shifting to a less accommodative policy stance. This will create an environment where global bond yields will rise but with credit markets outperforming government bonds. The story will play out differently in the latter half, however, as worries over global growth expectations for 2018 will create more market volatility - albeit with lower cross-asset correlations as central banks act in a less-coordinated fashion than in recent years. Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Top-Down Bond Portfolio Implications Of Our Key Views The main predictions for 2018 in our Key Views report from December 5th were the following: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. The first step in translating these themes into allocations into our model bond portfolio is to determining the ideal top-down asset allocation parameters for the start of the 2018: Maintain a moderate overall level of portfolio risk. Both bond yields (Chart 1) and credit spreads (Chart 2) are at the low end of their historical ranges since 2000. This suggests that bond market returns will be much lower than in recent years, simply because initial valuations are not cheap. Coming at a time when bond volatility is also at historically depressed levels, and with central banks starting to slowly take away the monetary punch bowl, keeping overall portfolio risk at modest levels is prudent. Within the GFIS model bond portfolio, that means keeping our tracking error versus our custom benchmark performance index well below our maximum target level of 100bps (Chart 3). Chart 1Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 Chart 2Historical Range Of Global Credit Spreads, 2000-2017 Maintain a below-benchmark overall portfolio duration. The combination of solid global growth, rising inflation and a slower pace of bond buying by the major central banks all suggest that bond yields will move higher in 2018. We will continue to target a recommended portfolio duration that is one year short versus our benchmark index (Chart 4). Chart 3Maintain Moderate Overall Portfolio Risk Chart 4Stay Cautious On Duration Risk Maintain an overweight stance on corporate credit over government bonds, focusing on the U.S. Although spreads are tight in so many asset classes, the global growth and monetary backdrop remains supportive for the outperformance of credit over government bonds. We recommended focusing on U.S. corporate credit, both Investment Grade (IG) and High-Yield (HY), where growth momentum remains solid and Fed policy is not yet restrictive. After setting those broad portfolio parameters, our recommendations get more interesting in terms of country allocations. Bond yields within the developed markets have become highly correlated to inflation expectations in the past few years (Chart 5). This is no surprise given how strongly central banks have tied their monetary policy decisions to their own inflation forecasts, and to market-based and survey-based inflation expectations. Inflation is likely to move higher next year alongside tight global labor markets and higher oil prices. If the bullish views on oil from BCA's commodity strategists comes to fruition, this implies that both market-based inflation expectations can rise and yield curves can bear-steepen. The key to the latter will be how fast central banks respond to faster rates of inflation. Yield curve steepness remains highly correlated to the level of REAL interest rates. Curves steepen when real interest rates decline and vice versa. Lower real rates can happen in two ways - bullishly, if central banks cut policy rates faster than inflation is falling; or bearishly, if central banks do not hike rates as fast as inflation is rising. We see the latter as being the likely story in 2018, which will lead to steeper government bond yield curves but through higher yields and rising inflation expectations. In Chart 6, where we plot the level of real central bank policy rates (deflated by 10-year CPI swaps as a measure of inflation expectations) vs. the 2-year/10-year bond yield curves. If global inflation expectations merely follow the path implied by our bullish oil forecast (Brent crude average $65/bbl in 2018), and central banks did not respond with rate hikes, then this would generate lower real interest rates (the "x" in each panel of the chart) and steepening pressure on yield curves. Chart 5Bond Yields In 2018 Will Be Driven More##BR##By Inflation Expectations Chart 6Steepening Pressure On Yield Curves##BR##From Inflation In 2018 We don't see all central banks responding the same way to an oil-driven move higher in inflation. Lower unemployment rates, and other measures of diminished economic slack, will be needed to give policymakers confidence that their economies can tolerate higher interest rates. Judging central banks along these lines will create more interesting country bond allocation decisions in 2018 (Chart 7). Specifically, we see a greater likelihood that the Fed and Bank of Canada (BoC) can actually raise interest rates next year. It will be much harder for the Bank of England (BoE) to raise rates given sluggish domestic economic growth, lingering Brexit uncertainty and the fact that market-based inflation expectations have already peaked. The Reserve Bank of Australia (RBA) will also be unable to hike rates next year given the lack of core inflation pressures and with an unemployment rate that is still much higher than previous cyclical troughs. This leads us to add moderate portfolio overweights in the U.K. and Australia to the government bond portion of our model bond portfolio, while maintaining our current underweight stances for the U.S. and Canada (Chart 8). The ECB and Bank of Japan (BoJ) will be nowhere near a point where interest rate hikes would be considered, although the decisions those banks make with their asset purchase programs will be a bigger issue for their bond markets in 2018. Chart 7Tight Labor Markets Will##BR##Influence Bond Returns Chart 8Monetary Policy Divergences##BR##Will Drive Country Allocation Bottom Line: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. The Asset Allocation Implications Of Slower Central Bank Asset Purchases The big risk factor for global bonds in 2018 will be how markets respond to less buying from the Fed, ECB and BoJ. As the growth rate of the expansion of the major balance sheets slows, bond yields have the potential to rise through two channels: higher term premia on longer maturity bonds and the market pulling forward the expected future path of interest rates. This will become a major issue for Euro Area bond markets in the 2nd half of 2018, as the ECB will be forced by strong domestic growth and rising inflation pressures to announce a full taper of its asset purchase program by the end of 2018. This will come on top of a slower pace of buying by the BoJ (who is now targeting a price target on bond yields rather than a quantity target), and the Fed allowing some run off of its massive balance sheet. The result is that the growth rate of the major developed market central bank balance sheets is likely to slow to a low single-digit pace in 2018 (Chart 9), creating upside potential for global yields. The case for significant underweights in Euro Area fixed income will be much stronger later next year when the ECB will be forced to prepare the market for a taper. But in the first half of 2018, the impact of the ECB's purchases will continue to dampen Euro Area bond yields. At the same time, Japanese yields will remain pegged near 0% by BoJ buying. In terms of our model bond portfolio, we are maintaining an overweight stance on low-beta Japan given our views on rising global bond yields, while keeping aggregate Euro Area bond weightings close to neutral (and looking to go more aggressively underweight later in the year as the ECB taper talk ramps up). Bond markets that are less propped up by ultra-accommodative central banks will create a more volatile market backdrop for global fixed income as the year progresses. That is hardly a provocative statement, of course, given the starting point of utterly low realized bond market volatility (Chart 10). As discussed earlier, our views for 2018 lead us to recommend a more moderate portfolio risk level in 2018. The potential for higher central-bank driven market volatility fits with that expectation. Chart 9Global Yields Will Rise As##BR##Central Banks Buy Fewer Bonds Chart 10The Low Bond Vol Regime##BR##Looks Stretched A slower pace of central bank bond buying also has another implication for portfolio construction. With the wave of central bank liquidity becoming a less dominant factor, cross-asset correlations should diminish. We can see that by looking at the average correlation between sectors within our model bond portfolio benchmark index (Chart 11). We have found that the correlation is itself highly correlated to the breadth of global economic growth, as measured by our leading economic indicator diffusion index (top panel). But the average correlation is also linked to the growth rate of central bank balance sheets (bottom panel), which is a by-product of massive asset purchases reducing global macroeconomic risks and forcing investors to plow into similar asset classes to chase acceptable returns. Slightly less coordinated global growth, and less active central banks, should result in lower market correlations in 2018. At the same time, as central banks shift to a less accommodative stance - especially in the U.S. - the uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart 12). This will likely lead us to cut our recommended overweight allocations to U.S. IG and HY corporate debt in our model portfolio later in 2018. To begin the year, however, we are keeping an overweight stance until the Fed is forced to signal a shift to a more hawkish stance because of rising U.S. inflation. Chart 11Expect Lower Global Bond##BR##Correlations In 2018 Chart 12The Link Between U.S. Growth,##BR##Bond Vol & Credit Spreads Bottom Line: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Summing It All Up Chart 13Aiming For Moderate Carry##BR##In Our Model Portfolio On Page 12, we show our model bond portfolio allocations after making some changes to reflect our key views for 2018. We are doing some tweaks to our existing recommendations: modestly increasing our overweight U.S. IG corporates allocation at the expense of U.S. Treasuries; reducing our underweight in the Euro Area by reducing the large Italy underweight; adding exposure to the U.K. and Australia; while cutting our large overweight in Japan. The latter was there as a desire to get more defensive on the portfolio's duration stance, but having such a large allocation has left our portfolio with no yield advantage versus the custom benchmark index (Chart 13). With the changes we are making this week, the model bond portfolio will have a yield that is 12bps over that of our custom index. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy The easy money has already been made in the liquidity-to-growth theme-levered long S&P energy/short global gold miners pair trade. Lock in profits and move to the sidelines, for now. Similarly, book gains in the long S&P materials/short S&P utilities market-neutral trade. A stealthy macro shift, at the margin, suggests that a more challenging phase lies ahead for this relative share price ratio. Recent Changes Book 18.3% profits in the long S&P energy/short global gold miners pair trade today. Take profits in excess of 8.6% in the long materials/short utilities pair trade today. Table 1 Feature Equities continued to defy gravity last week, vaulting to fresh all-time highs. Seasonality (or the pending Santa rally) appears to have trumped any "buy on rumor sell the tax news" jitters, at a time when macro data continue to surprise to the upside. Heading into 2018, easier fiscal policy will likely offset some of the uneasiness of the Fed's ongoing tightening cycle as we postulated in early October.1 Synchronized global economic and capex growth remain the key macro themes that dominate markets. The latest GDP revisions in the G3 confirm our global capex upcycle bias: U.S., euro area and, especially, Japanese gross fixed capital formation are on fire (Chart 1). Importantly, once the tax bill related dust settles, profits will come back to the forefront as a key stock market driver. In that regard, the news on the EPS front is ebullient and, along with the forward multiple, all that matters. Table 2 shows annual SPX returns going back to 1979, and breaks down the composition of the capital (not total) return into two components: forward earnings growth and the forward P/E multiple (January 1979 is the first IBES data point for forward EPS SPX estimates). Chart 1Synchronized Global Capex Table 2Disentangling SPX Returns Currently, sell side analysts expect 11% EPS growth for 2018, and our sense is that 8-12% EPS growth is achievable next year, a message that our SPX EPS macro model corroborates (Chart 2). Keep in mind that there is no tax cut penciled into our EPS model's numbers. Chart 2SPX EPS Macro Model Flashing Green What is interesting from the multiple/EPS analysis is that over the last four decades when forward profit growth was in this high single-digit / low double-digit range (ten iterations), the multiple expanded modestly (on average, adding 2.6 percentage points to the market's return) and EPS did the heavy lifting (explaining, on average, roughly 80% of the S&P 500's 12.9% average annual return, Table 3). If we consider periods when EPS growth was positive but below 8% (eleven iterations), SPX returns are close to 10%, on average, with EPS and the multiple contributing almost equally to the market's return. One caveat is that two recessionary years and the dot com bust are part of this segment skewing the results to the downside (Table 3).2 Table 3Disentangling SPX Returns Continued Nevertheless, if history at least rhymes, were EPS growth to stay positive next year and hit the 8-12% mark, then a profit driven low double-digit broad equity market return is likely. If profits disappoint and grow between 0-8%, barring recession, empirical evidence suggests that equity returns will still prove healthy. Adding it up, the path of least resistance is higher for equities on a cyclical 9-12 month horizon. Granted, since Brexit the SPX has rallied in a near straight line up and a healthy and temporary pause for breath is likely in Q1/2018. As a result, this week we are booking impressive gains in two tactical market-neutral trades we initiated in late-August and mildly de-risking our portfolio. Lock In Profits In The Long Energy/Short Gold Producers Trade In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3%. It also sports a positive annual dividend carry of 200bps. With the equity market overshoot phase likely going on hiatus sometime in early 2018 is it still prudent to hold this high-octane intra-commodity and market-neutral trade? The short answer is no. Nothing in terms of macro data has changed to trip up this pair trade. If anything, the handoff of global liquidity to economic growth has gained steam in the past few months. Global GDP, IP, manufacturing PMIs, global trade (Chart 3) and gross capital formation are all growing simultaneously across all of the G7 and most of the EMs. Even China's economy seems to have stabilized. The Fed announced its plans to wind down its balance sheet as expected in September and the BoE and BoC have both tightened monetary policy. Even the ECB announced a halving of the size of its monthly purchases in late-October (but extended it for nine months). All these central bank (CB) moves suggest that, at the margin, the global liquidity injection is reversing, with CBs actually mopping up liquidity. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (Chart 4). Chart 3Brisk Global Growth... Chart 4...Higher Rates... Moreover, geopolitical uncertainty is steadily receding, especially now that the Senate also passed a tax bill, and a final bill will likely soon be signed into law.3 Historically in times of duress, safe haven assets are bid up and vice versa, and the current low policy uncertainty backdrop is conducive to additional gains in the relative share price ratio (policy uncertainty shown inverted, Chart 5). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners. The oil and gas rig count has resumed its advance and remains 150% clear of the lows hit during the depths of the global manufacturing recession of late-2015/early-2016. Anecdotes of global oil majors comfortably registering positive EPS, in the new era of $50/bbl oil, and reinstating stock buybacks and eliminating scrip dividends (RDS, BP & ENI) suggest that the worst is behind the industry. In contrast, safe haven asset demand is in retreat and will continue to weigh on global gold ETF flows. Anecdotally, the BITCOIN/ICO/cryptocurrency mania may also steal some of bullion's thunder, as this mania is capturing investor's imagination. Either a flare up in global geopolitical risk or a global growth scare could cause investors to start shifting capital into gold ETFs. Our relative EPS models do an excellent job in capturing this energy positive/gold negative backdrop and continue to suggest that energy profits will outpace gold mining EPS (Chart 6). Chart 5...And Diminishing Uncertainty##br## Still Bode Well For The Trade Chart 6But We Do Not Want To##br## Overstay Our Welcome If these different macro and operational forces all emit an unambiguously bullish signal for S&P energy shares compared with global gold miners, why book profits? Our sense is that there are high odds of a pullback in Q1/2018 and from a portfolio management and risk perspective it is prudent to lock in handsome profits in excess of 18.3% in a four month period. There are high odds that most of these key drivers are reflected in relative share prices versus late-August. Relative valuations are pricier today and technicals are also flashing yellow (bottom panel, Chart 4). We deem that the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. This was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Were the broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now. Take Profits In Materials Vs. Utilities Similar to booking gains in the liquidity-to-growth levered market-neutral long S&P energy/short global gold miners pair trade, we also recommend taking profits in the reflation levered long S&P materials/short S&P utilities pair trade. Since its late-August inception this market-neutral trade has generated returns in excess of 8.6% and added alpha to our portfolio. While overall macro conditions continue to underpin the relative share price ratio, some cracks are appearing on the surface. Global reflation has matured and synchronized global growth is as good as it gets. The ISM manufacturing and services surveys have ticked down in sympathy recently, warning that the easy gains are behind this market neutral trade (Chart 7). Worrisomely, our relative sector Cyclical Macro Indicators are sniffing out this marginal shift in the macro backdrop and suggest that a more challenging phase lies ahead for the relative share price ratio (Chart 8). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018. This is one of our key themes for next year, and given that this trade typically moves in lockstep with interest rates, the path of least resistance is higher. Nevertheless, the fact that this ratio has not kept up with the slingshot recovery in the stock-to-bond (S/B) ratio is slightly disconcerting. The top panel of Chart 9 shows that the gap between the S/B and the materials/utilities ratios has widened further since late-August. Chart 7As Good As It Gets? Chart 8Fatigue Signs Chart 9More Balanced Backdrop=Move To The Sidelines On the operating front, our relative EPS models are also showing signs of fatigue. Materials profits cannot expand indefinitely at the breakneck pace observed since the 2016 trough, at a time when utilities EPS have stabilized. Currently, the relative earnings models suggest that materials are on an even keel with utilities (Chart 9). Tack on rising odds of a healthy broad market pullback in Q1/2018, and from a risk management perspective we would rather de-risk the portfolio a notch by locking in near double-digit gains since inception in this volatile pair trade. Bottom Line: Book gains of 8.6% in the long S&P materials/short S&P utilities pair trade. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 For reference and completion purposes Table 3 also tabulates the results during EPS contractions (nine iterations) and in profit boom times, i.e. forward EPS growth north of 12% (nine iterations). 3 Please see BCA U.S. Equity Strategy & Geopolitical Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights BCA expects the 2/10 curve to steepen in 1H in 2018, then flatten in 2H. U.S. equities, the stock-to-bond ratio and oil thrive when the curve is flat. Small caps struggle. Record household net worth matters more for household saving than for consumption. Feature Wrangling over the GOP's tax plan and the Federal Open Market Committee's final meeting of 2017 provided the backdrop for financial markets last week. The dollar was the big loser, as investors doubted the ability of the Republican leadership in Congress to find the votes needed to pass the bill. BCA's view remains that Congress will pass a tax cut package by the end of Q1 2018. Even though inflation missed the Fed's forecast in 2017 (Chart 1), the FOMC left its inflation and interest projections unchanged for the next two years given its outlook for stronger growth and lower unemployment. Inflation will reach the 2% target by the end of 2019. As a consequence, the Fed expects to lift interest rates three more times in 2018 and another two times in 2019 (Chart 2). Chart 1Persistent Inflation Shortfall Chart 2The FOMC's Latest Forecasts The economy is now expected to grow 2.5% in 2018, up from the Fed's previous forecast of 2.1%. Growth is seen remaining above the 1.8% trend rate for three years. The Fed nudged its forecasts for the unemployment rate down by 0.2% for the next three years, based on the higher growth projections. The jobless rate is now expected to dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. If anything, these forecasts look too conservative. Importantly, the Fed left its estimate for long-run unemployment unchanged at 4.6%. Therefore, the labor market is expected to tighten further beyond full employment. Consequently, wage gains should accelerate and allow inflation to return to the Fed's 2% target in 2019. We don't have any major disagreements with the Fed's interest rate forecasts for 2018, but inflation must turn higher. The Fed has raised rates five times over the last two years, but CPI inflation has made no progress toward the 2% objective. However, the New York Fed's Underlying Inflation Gauge continues to move steadily higher (Chart 1, panel 1). Nevertheless, the real Fed funds moved closer to its neutral level and the yield curve has continued to flatten (panel 3). Bottom Line: BCA expects the yield curve to steepen in the first half of 2018, driven either by rising inflation or a more dovish Fed. However, a flat curve is not the death knoll for risk assets. The yield curve will not invert until inflation has recovered to the Fed's target. This means that a period of modest curve steepening is likely, driven either by rising inflation or a more dovish Fed. Powell Versus The Market BCA's view is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates, but inflation fails to rise, then the yield curve will invert in the coming months. The inversion would signal that bond investors anticipate a recession and the Fed has not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves three possible outcomes for Fed policy and the Treasury curve during the next six months.1 1) The Fed Is Right In this scenario, inflation would rebound in the coming months, pushing up the compensation for inflation protection embedded in long-dated bond yields. This would cause an increase in long-maturity nominal yields and probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates. BCA's Outlook for 2018 makes a case why inflation will likely bottom in the coming months. Therefore, we view the "Fed is Right" scenario as the most probable outcome.2 2) The Fed Is Proactive In another scenario, the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. Therefore, the Fed may proactively adopt a more dovish policy stance to prevent the yield curve from inverting. The yield curve would also steepen, but this time it would be a bull-steepener where short-maturity yields fall more than long-maturity yields. This outcome would be the least likely of our three scenarios. The Fed will cling to its forecast that inflation will climb, given that economic growth is accelerating. If inflation fails to respond, then risky assets will eventually sell-off. 3) The Fed Is Reactive The Fed has a strong track record of reacting to tighter financial conditions and risk-off periods in equities and credit markets. If the yield curve continues to flatten, then we will soon see credit spreads widen and equities sell-off. At that stage, the Fed would almost certainly respond by signaling a slower pace of rate hikes. This would steepen the curve and ease pressures on risky assets. We view this development as more likely than the one where the Fed is proactive. Trouble With The Curve BCA's U.S. Bond Strategy team expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 53 bps in mid-December 2017 through mid-year 2018, and then flatten into year-end. Which asset classes would benefit if BCA's curve call is accurate? Charts 3 through 7 show how several key financial markets have performed in previous yield curve environments. Chart 3A shows that the S&P 500 performs best when the curve is flat (between 0 and 50 bps), with average annualized returns of 22% and median annualized returns of 21%. Moreover, S&P 500 returns are negative less than 5% of the time when the curve is flat, but are negative 25% of the time when the curve is very steep (+100 to +150 bps) (Chart 3B). In general, Chart 3A demonstrates that returns diminish as the curve climbs. Chart 3AS&P 500 Total Return & Yield Curve##BR##(1988- Present) Chart 3BPercent Of Months With Negative##BR##S&P 500 Returns (1988- Present) A flat slope of the 2/10 curve is also the sweet spot for the stock-to-bond ratio (Chart 4A). Treasuries outperform stocks only in 5% of months when the 2/10 Treasury curve is flat (Chart 4B). As with stocks, the performance of the stock-to-bond ratio deteriorates as the curve steepens. The stock-to-bond ratio declines more than a third of the time when the curve is very steep. A 2/10 slope of +100 to +150 bps is the worst backdrop for the stock-to-bond ratio. Stocks underperform bonds 40% of the time in this situation. Chart 4AStock-To-Bond Total Return & Yield Curve##BR##(1988 - Present) Chart 4BPercent Of Months With Negative##BR##Stock-To-Bond Total Return (1988 - Present) However, a flat curve is a poor setting for small-cap excess performance (Chart 5A). Small caps underperform large caps nearly 80% of the time when the curve is flat (Chart 5B). The average underperformance is 600 bps. Moreover, a flat curve is the most unhealthy climate for small-cap excess returns, even poorer than when the curve inverts. A precipitous curve is the best environment for small caps, with small caps outperforming large by 400 bps on average. Small caps beat large caps 60% of the time when the curve is between 100 and 150 bps. Chart 5AS&P Small/Large TOTAL Return & Yield Curve##BR##(1988- Present) Chart 5BPercent Of Months With Negative##BR##S&P Small/Large Total Return (1988- Present) Our U.S. Bond Strategy colleagues note that the flatter the curve, the higher the risk of a sell-off in high-yields relative to Treasuries.3 Junk bonds underperform Treasuries 48% of the time when the curve is flat, which we expect in 2018 (not shown). The implication for investors is that the first half of 2018 will be the best period for junk bond returns. Investment-grade corporates have a similar return profile relative to the curve. Oil performs best when the 2/10 curve is inverted (Chart 6A). However, WTI oil returns an annualized 10-15% when the curve is between 0 and 100 bps. Plus, oil is higher 75% of the time when the curve is between 50 and 100 bps, which is the environment we expect in the first half of next year (Chart 6B). Chart 6AWTI Crude Oil Price Return & Yield Curve##BR##(1988- Present) Chart 6BPercent Of Months With Negative##BR##WTI Crude Oil Price Return (1988- Present) Forward earnings per share perform well with a flat curve, but earnings growth is optimal when the curve is inverted. The steeper the curve, the bigger the headwind for EPS. Since 1988, earnings growth has been positive when the curve inverts and is positive 95% of the time when the curve is flat. Chart 7 provides the historical context for a flat yield curve (0 to 50 bps) in terms of the performance of stocks, Treasury bonds, the stock-to-bond ratio, small caps and oil. The Appendix (see page 13) also includes three other charts that provide a perspective on asset class performance when the curve is moderately steep (50 to 100 bps), steep (100 to 150bps) and above 150 bps. Chart 7Stocks, Treasuries, Small Caps And Oil When The Curve Is Flat Bottom Line: BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive next year; earnings growth is higher 75% of the time when the curve is flat. Household Net Worth Loses Influence Chart 8The Consumer Is In Good Shape U.S. consumer health has improved markedly since early this year, driving BCA's Consumer Health Indicator into positive territory (Chart 8). These elevated readings should bolster household consumption well into 2018. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least over the next 12 months. Real consumer spending is underpinned by advances in real disposable income stemming from increasingly healthy labor market. Moreover, household net worth has continued to soar to an all-time high in 2017Q3 as equity markets remain frothy and house prices stable. However, net worth's direct influence on overall household consumption is not as significant as before the Great Recession. During the housing bubble in the early 2000s, U.S. households leveraged their spending through extensive mortgage refinancing and mortgage equity withdrawal. Real estate was the principal holding on most households' balance sheets. However, as the Great Recession unfolded, household net worth suffered with a collapse in both house prices and equity markets. By 2009, U.S. households were tapped out and grossly over-indebted. Deleveraging is now over, U.S. households have re-fortified their balance sheets and consumer spending is back in line with income growth. In the long term, inflation-adjusted disposable income is more highly correlated with inflation-adjusted consumer spending growth than real household net worth (Chart 9). Positive momentum should continue to support further real consumer spending over the next few quarters, given that unemployment is at a 17-year low and consumer confidence is at a 17-year high, and also given elevated consumers' expectations of real income gains over the next year or two. Chart 9Consumer Spending More Correlated With Income Than Net Worth Household net worth matters more for household saving than for consumption. Chart 10 shows the inverse relationship between net worth and the saving rate. Empirical research has demonstrated the risk that the structural decline (since the mid-1990s) in personal savings has on consumer spending and the overall economy. An often cited conclusion drawn by the investment community is that a lower savings rate raises the risk of consumer retrenchment.4 Chart 10Low Savings Rate, Record High Household Net Worth And Rising Income Expectations Even though the personal savings rate can be considered a contrarian measure for consumer spending, like many measures from the BEA national accounts (NIPA), it is subject to regular revisions. Over the long-term, according to the BEA, the level of the savings rate is often revised upwards but the trend over the last 45 years remains unchanged. There was a downtrend path to revisions in the mid-2000s housing bubble, but there has been a subtle uptrend since 2008 (Chart 11). Even so, in the long run, BCA views the low personal savings rate as a potential headwind for consumer spending as it cannot sustainably remain at its recovery low of 3.2%. However, rising income expectations and a sturdy labor market are offsets to depressed savings and will ensure that the economic expansion remains sustainable and, therefore, less vulnerable to volatile saving patterns. Does record high net worth alter the risks to the FOMC's goals of price stability and sustainable economic growth? In a recent research paper, the Federal Reserve of St-Louis looked at the most exuberant peaks in the ratio of household net worth to income in 1999 and 2006, which occurred before collapses in asset prices and recessions. Although caution is prescribed as household net worth keeps making new highs, the report noted that the composition of households' balance sheet is less alarming today than prior peaks, as equities and real estate relative to household income or total assets are more reasonable. Debt levels are also much more tame today than in 2006. With more immune balance sheets, households may be less vulnerable to unexpected shocks in the future (Chart 12).5 BCA's view is that financial vulnerabilities from the household sector are well contained. Outside of subprime auto loans, household borrowing is increasing modestly at an annual pace of 3.6%, in stark contrast with a 12.9% rate in the early-to-mid 2000s. Broad measures of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recession levels. Furthermore, liquidity buffers (liquid assets to liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 13). Chart 11Savings Rate Level Often Revised Upwards Chart 12Household Sector Balance Sheet Composition Chart 13Household Sector Buffers Are Solid BCA expects the Fed to remain vigilant about financial stability.6 Policymakers will take comfort that household liquidity and solvency ratios have improved dramatically in the past nine years, aided by the cumulative gains in housing and financial assets. Bottom Line: The outlook for the U.S. consumer is bright as incomes continue to improve amid tight labor market conditions. However, record household net worth is more relevant today for savings than for consumption. The Fed should remain committed to gradual rate hikes, but the central bank's quandary will be to determine the optimal pace to foster maximum employment and price stability. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Research's "2018 Outlook Policy And The Markets: On A Collision Course ," published December 2017. Available at bca.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 4 "Should The Decline In The Personal Savings Rate Be A Cause For Concern?", Alan C. Garner, The Federal Reserve Bank of Kansas City, 2006Q2; and "The Decline in the U.S. Personal Savings Rate: Is It Real and Is It A Puzzle?", Massimo Guidolin and Elizabeth A. La Jeunesse, The Federal Reserve Bank of St-Louis, November/December 2007. 5 "Household Wealth Is At A Post-WW II High: Should We Celebrate or Worry?", William R. Emmons and Lowell R. Ricketts, Federal Reserve Bank of St-Louis, In the Balance, Perspectives on Household Balance Sheets, May 2017. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Powell's In Power," published on November 6, 2017. Available at usis.bcaresearch.com. Appendix Chart 14U.S. Financial Markets When The 2/10 Curve Is Between 50 And 100 Bps Chart 15U.S. Financial Markets When The 2/10 Curve Is Between 100 And 150 Bps Chart 16U.S. Financial Markets When The 2/10 Curve Is Steeper Than 150 Bps
Highlights The dollar has decoupled from interest rate differentials, being hurt by buoyant global growth. For the dollar to weaken more in 2018, global growth will have to accelerate further from current lofty rates. The tightening in Chinese policy along with the poor performance of EM carry trades point to a slight slowdown, not an acceleration. A pick up in volatility would magnify the underperformance of EM carry trades, and thus, tighten global liquidity conditions. This will help the dollar, but could help the yen even more. Buy NOK/SEK. Feature This past Wednesday, the Federal Reserve increased its growth forecast through 2020. It also cut expectations for the U.S. unemployment rate in 2018 and 2019 to 3.9%, and finally it increased its interest rate forecast to 3.1% by 2020. Yet, the U.S. dollar weakened substantially. Even if we acknowledge that interest rate markets are skeptical that the Fed will be able to fulfill its promises, the U.S. dollar has also decoupled itself from market interest rates. While rate spreads between the U.S. and the rest of the world point to a higher USD, the dollar is in fact gaining no traction (Chart I-1). We think global growth has been the key to this conundrum. Global Growth Steals The Limelight Interest rate differentials are the most common driver of exchange rates, but sometimes, growth dynamics also play a role. Currently, strong global growth stands firmly in the driver's seat, explaining why the dollar is weakening. Generally, when non-U.S. activity improves, the dollar underperforms (Chart I-2). Chart I-1Dollar And Rates Spot The Disconnect Chart I-2The Dollar Doesn't Like Strong Global Growth The reason is straightforward, and has two main elements. First, the U.S. is a low-beta economy. When global growth accelerates, the U.S. does not benefit as much as Europe. The IMF estimates that a 1% gyration in EM activity affects euro area growth three times as much as it impacts the U.S. Not only is EM activity a key source of variance in the global industrial cycle, it has also been the key factor behind this upswing. Second, money tends to flow out of the U.S. when global growth accelerates. Since non-U.S. economies are more levered to the global industrial cycle than the U.S., so is their profit growth. Additionally, an accelerating global economy is associated with a rise in central bank foreign exchange reserves outside of the U.S. as global trade expands. This creates generous liquidity conditions in the rest of the world, which further favors economic growth and asset price expansion. Money flows where higher returns are to be found. In recent quarters, global reserves have indeed expanded, highlighting this easing in global liquidity conditions (Chart I-3). To bet on the U.S. dollar weakening is to bet on this set of conditions continuing. This is the wager market participants are currently making. Investors are very short the U.S. dollar index and very long the euro, the CAD, the AUD, gold and oil (Chart I-4). This suggests that even a mild slowdown in global growth would indeed be a surprise - one that would cause the dollar to move back toward levels implied by interest rate differentials (Chart I-5). Chart I-3Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Chart I-4Investors Are Short The Dollar Long Growth Chart I-5Dollar Is Cheap Relative To Rates Bottom Line: A key factor behind the dollar's weakness in 2017 has been the positive global growth surprise. This helps explain why the dollar has been much weaker than interest rate differentials would otherwise suggest. Since the dollar is trading at such a discount to interest rate differentials, for the greenback to weaken further global growth needs to continue to accelerate. Based on positioning, the surprise for investors would be if global industrial activity decelerates. Risks To Global Growth Chart I-6China Helped Australia The acceleration in global growth needed for the dollar to sell off more is unlikely to emerge. To the contrary, growing evidence indicates that a mild slowdown is likely to hit global industrial activity next year. One of the key pillars for global growth, China, is turning the corner. China has played an essential role in explaining the strong growth of many economies in 2017. The link for EM or commodity producers like Australia to Chinese growth is relatively self-evident. For example, the value of Australian exports received a strong fillip when Chinese industrial activity surged in 2016 and 2017. As such, the recent rollover in the Li Keqiang index - a key gauge of China's secondary sector - points to a reversal in Chinese growth (Chart I-6). Chinese activity also has important implications for the performance of growth in the euro area relative to the U.S. As Chart I-7 highlights, when Chinese monetary conditions ease or when the Chinese marginal propensity to save - as approximated by the gap between the growth rate of M2 and M1 - decreases, the Eurozone's economy accelerates relative to the U.S. Currently, Chinese monetary conditions are tightening and the marginal propensity to save is rising, highlighting that European growth will decelerate relative to the U.S. Chart I-7AChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) Chart I-7BChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) The outlook for Chinese growth suggests that the recent reversal in industrial activity could run a bit deeper. Arthur Budaghyan, who leads BCA's Emerging Markets Strategy service, has highlighted that Chinese broad money growth is decelerating, and that the Chinese fiscal impulse is slowing. This is normally associated with falling Chinese imports, which is China's direct footprint on the global economic cycle and global trade (Chart I-8). Moreover, Chinese borrowing costs are rising and the real estate sector is already showing signs of slowing. The amount of new floor space sold is now contracting, which often precedes serious decelerations in new house prices (Chart I-9, top panel). Thus, Chinese construction is likely to contribute less to global growth and to demand for commodities in the coming year than in the past two years. Chart I-8Slowing Chinese Money Is A ##br##Headwind For Global Activity Chart I-9Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Meanwhile, China has overinvested in its capital stock when compared with other EM economies at similar stages of development (Chart I-9, bottom panel). Therefore, the risk that capex will slow in response to policy tightening is high. This would further weigh on Chinese imports. Various Chinese leading economic indicators have also rolled over sharply. This portends a further fall in the Li Keqiang index (Chart I-10) and also gives more credence to our view that China's industrial activity and imports will slow in 2018. As BCA's Geopolitical Strategy team has argued, the willingness of the Chinese authorities to implement reforms and control credit growth next year will only solidify this negative impulse.1 It is not just Chinese variables that are deteriorating, but other key leading indicators of the global industrial cycle seem to be picking up on this impulse (Chart I-11). The recent deceleration in global money growth also confirms this insight (Chart I-12). Chart I-10Chinese Monetary Conditions ##br##Point To Slowing Industrial Activity Chart I-11Global Growth Gauges Corroborate ##br## Chinese Indicators Chart I-12Where Global Money Growth Goes, ##br##So Does Activity Most importantly, the performance of our EM Carry Canaries - how key EM carry currencies are performing against the quintessential funding currency, the yen, corroborates this picture. EM carry trades' total returns have sharply rolled over, a signal that has always led to a slowdown in global industrial activity for the past 20 years (Chart I-13). We argued two weeks ago that EM carry trades are beginning to weaken because of the negative impulse emanating from China. We also stressed that the relationship between EM carry trades and global industrial activity is strengthened by the role carry trades play in disseminating and enhancing global liquidity.2 Strongly performing EM carry trades are a symptom of liquidity making its way across the globe, leading to supportive conditions for risk assets and growth. On the other hand, an underperformance in EM carry trades is an early signal that liquidity is on the wane, pointing to an upcoming downturn in risk taking and economic activity. Going forward, there is a growing likelihood that policy within developed markets will amplify the weakness in EM carry trades that currently reflects mostly changing growth dynamics in China. Global volatility has been extremely muted in 2017, which normally helps carry trades perform well. However, as Chart I-14 illustrates, volatility tends to experience upside when U.S. inflation picks up. This is because as inflation picks up, not only does the Fed increase rates, which tightens global liquidity conditions and hampers risk taking, but the path for future growth also becomes trickier to discount, requiring higher volatility in the process. BCA expects U.S. inflation to pick up significantly in 2018. The rise in the growth of the velocity of money in the U.S. is one of the clearest indications of that risk (Chart I-15). Chart I-13EM Carry Trades Are Confirming These Trends Chart I-14Global Vol Will Rise With Inflation Chart I-15U.S. Core Inflation Has Upside The tax repatriation included in the U.S. Tax Cuts and Jobs Act represents an additional risk for global aggregate volatility. When U.S. entities repatriate dollars back home, this curtails the supply of USD collateral available in the offshore market. As a result, dollar funding becomes scarcer, creating widening pressures on USD cross-currency basis swap spreads (Chart I-16, top panel).3 The introduction in January of rules by the BIS for banks to hold greater collateral against OTC transactions will further exacerbate this potential dollar squeeze in the swap market, increasing the risk that the U.S. tax bill will result in wider USD basis-swap spreads. Historically, wider swap spreads haven been associated with rising volatility, a logical consequence of more expensive funding (Chart I-16, bottom panel). This rise in volatility is likely to aggravate the weakness in EM carry trades. This will amplify the risks to global liquidity. As this process unfolds, global growth will begin to slow, precisely at the time when investors are not positioned for it. Bottom Line: Global growth is being hit by the beginning of a slowdown in Chinese industrial activity. This slowdown does not constitute a crisis, nor a repeat of the 2015 period of elevated risks for China. However, it does nonetheless create a headwind for global industrial activity that is already being picked up by key reliable gauges of global growth. Moreover, EM carry trades, which have been an extremely reliable leading indicators of global growth, are already corroborating this picture. Since volatility is set to increase in 2018 as U.S. inflation picks up and U.S. tax repatriation dries global dollar funding, the downside in EM carry trades has further to go which will result in tighter global liquidity conditions, in turn increasing the probability that global growth will disappoint. Global Growth, U.S. Policy, And The Dollar We began this report by highlighting that since the dollar is now trading at a substantial discount to interest rate differentials, betting on a weaker dollar is akin to betting on additional strengthening in global growth. However, the factors highlighted above argue against an acceleration in global growth, especially in global industrial activity. Moreover, global growth is set to decelerate while the Fed is hiking rates - a scenario reminiscent of the late 1990s. In fact, the gap between growth indicators and the Fed's policy setting has in the past been a useful tool in pinpointing dollar bull and bear markets (Chart I-17). Chart I-16Tax Repatriation Leads To Wider ##br## Swap Spreads And Greater Volatility Chart I-17A USD-Positive ##br##Dichotomy Thus, we continue to follow the scenario we elaborated on in early September:4 The dollar will end the year having generated positive but uninspiring returns during the fourth quarter. It will only gather steam in Q1 2018, once U.S. inflation picks up significantly. This rebound in U.S. core inflation will help the Fed fulfill its promise to increase rates three times next year. It will also create a non-negligible headwind to global growth by pushing volatility higher, hurting global carry trades and global liquidity conditions in the process. At this point, any move in DXY to 93 should be used to build bullish bets on the dollar. Conversely, moves in EUR/USD to 1.18 should be used to sell the USD. We remain short commodity currencies and our portfolio is especially negative on the AUD. Finally, we have professed a negative view on the JPY on the basis of higher U.S. rates. While higher U.S. rates may continue to lift USD/JPY, the window to be short the JPY is likely closing. If volatility does pick up on the back of the risks highlighted in this report, the yen could buck the dollar's strength and rally. We thus remain short NZD/JPY to protect against this eventuality, and we will look to close our long USD/JPY position around the New Year. Bottom Line: As global growth is set to slow somewhat, the Fed is redoubling on its hawkish rhetoric. Since the dollar is trading at a discount to interest rate differentials and is being sold by speculators, this raises the risk that the USD will experience a significant rally in the first half of 2018. Any move in the DXY to 93 should be used to build significant long positions in the USD, whether through the index or by shorting EUR/USD, or by betting on further AUD weakness. The yen could benefit in this environment. An Uncorrelated Trade: Long NOK/SEK It is always important to find potentially uncorrelated trades within a portfolio, as it increases diversification benefits. The FX space is no exception to this rule. Such an opportunity seems to be emerging in the European currency space: buying Nokkie/Stokkie. NOK/SEK currently trades at a large 8% discount to purchasing power parity. More sophisticated models incorporating productivity differentials and terms-of-trade shocks also show that the krone is cheap relative to its neighbor (Chart I-18). Moreover, the IMF expects the Norwegian current account to stand at 5.5% of GDP for 2017, while Sweden's will be a more modest 3.9% of GDP. This gap is anticipated to be maintained in 2018. In terms of catalysts for a rally in NOK/SEK, Sweden's relative economic outperformance that has been so vital to this cross's weakness is ebbing. Norwegian real GDP and industrial production growth are both accelerating relative to Sweden's. This trend looks set to endure as the Norwegian leading economic indicator is displaying a similar profile (Chart I-19). Confirming this picture, the Norwegian economic surprise index is turning up from exceptionally depressed levels when compared to Sweden's. Historically, this tends to translate into a stronger NOK. Yesterday's comments by Norges Bank Governor Oystein Olsen pointing to a first hike in late 2018 are helping catalyze the pricing of these dynamics in the cross's price. Financial markets are telling a similar story. Norwegian equities have been outperforming their Swedish counterparts since the middle of 2017. Moreover, Norwegian nominal and real yields are rallying relative to Sweden, which normally puts upward pressure on NOK/SEK (Chart I-20). Chart I-18NOK/SEK Is Cheap Chart I-19Growth Momentum Moving In Favor Of Norway Chart I-20Relative Yields Point To Higher NOK/SEK While a slowdown in global growth is a risk when holding a commodity currency like the NOK, NOK/SEK offers a healthy level of cushion against this eventuality. Overwhelmed by domestic fundamentals, NOK/SEK has decoupled from its historical relationship with EM equities, EM spreads, oil and global growth. Thus, this cross is not as levered to the global economic cycle as it normally is. In fact, BCA's view that oil prices have upside, especially relative to EM asset prices, points toward a higher NOK/SEK (Chart I-21). Finally, from a technical perspective, NOK/SEK looks interesting. The pair's 40-week rate-of-change measure is hitting oversold levels. More tellingly, NOK/SEK is forming an inverted head-and-shoulder pattern exactly as its 13-week rate of change loses downward momentum (Chart I-22). Chart I-21Liking Oil Relative To EM Stocks ##br##Is The Same Thing As Being Long NOK/SEK Chart I-22Favorable Technical ##br##Set Up Thus, we are buying NOK/SEK this week, with an entry point at 1.0163, a stop at 0.998, and an initial target at 1.08. Bottom Line: Buying NOK/SEK at current levels makes sense. Not only is it an uncorrelated trade with the dollar, but the pair is also cheap. Moreover, economic momentum, which was overwhelmingly in favor of the SEK, is now rolling in favor of the NOK, a message confirmed by financial market indicators. NOK/SEK is trading at cheap levels relative to global economic and financial variables, suggesting a cushion to negative shocks is in the price. Instead, NOK/SEK should benefit if oil prices outperform EM assets, a view held by BCA. Finally, the trade looks attractive from a technical perspective. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Reports, titled "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, and "China: Party Congress Ends... So What?" dated November 1, 2017, available at gps.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear," dated October 27, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar," dated September 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been mixed: Core CPI grew by 1.7% annually, lower than the expected 1.8%; Producer prices were strong annually at 3.1%, above the expected 2.9%; while the core measure also produced strong results of 2.4%, above the expected 2.3%; Retail sales were also quite positives, beating expectations by a wide margin. This week, in line with expectations, the Fed hiked rates to 1.25 - 1.5%. The FMOC also upgraded its growth forecasts while still penciling in three rate hikes for next year. However, Treasurys rallied and the DXY dropped 0.6%, showing that markets believe the Fed is potentially making a hawkish error inflation continues to underperform. We do agree with the Fed and we expect inflation be in the process of bottoming. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was generally positive: German ZEW Current Situation increased to 89.3 while economic sentiment declined to 17.4; European PMIs were very strong, with the manufacturing and services indices coming in at 60.6 and 58, respectively, both increasing and beating expectations. German inflation stayed steady and in line with expectations at 1.8%; French CPI underperformed expectations, growing at 1.2% annually; Italian inflation was in line with consensus at 1.1%; European growth is currently stellar, and markets have priced in this reality. The ECB agrees, and it has upgraded its growth and inflation forecasts up to 2020. Yet, even under the new set of forecasts, inflation fails to hit the ECB's target. With the end of the asset purchases program anticipated for the September 2018, the first hike could materialize in the second quarter of 2019, suggesting EONIA rates possess some genuine but limited upside from current levels. However, most importantly, we think that EONIA pricing will still lag the U.S. OIS going forward, putting downward pressure on EUR/USD. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been mixed in Japan: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Machinery orders yearly growth also outperformed expectations, coming in at 5%. Moreover, gross domestic product growth also outperformed, coming in at 2.5% in the third quarter. This was a significant improvement from the 1.4% growth number registered in Q2. However labor cash earnings growth underperformed expectations, coming in at 0.6%, suggesting still muted inflation pressures. Finally, housing starts growth surprised to the downside, coming in at -4.8%. After rising throughout the week, USD/JPY collapsed following the FOMC rate decision, as U.S. Treasuries rallied. Overall we continue to be bullish on the yen against risk-on currencies like the NZD and the AUD, as tightening Chinese financial conditions should set the stage for a temporary slowdown in global growth. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: Markit Manufacturing PMI outperformed expectations, coming in at 58.2. This number also increased from the October reading. Construction PMI also outperformed expectations, coming in at 53.1, and also increasing from the previous month's number. Headline inflation also outperformed expectations, with a reading of 3.1%. Nevertheless, core inflation came in according to expectations at 2.7% Finally, the trade balance also outperformed expectations on the month of October, coming in at -1.405 Billion pounds. The BOE's MPC left policy rates unchanged at 0.5%. Overall, we believe that in the short term, the ability of the BoE to continue to hike is limited, given that consumption remains sluggish and leading indicators of house prices still flag some frailty. Furthermore, the uncertainty surrounding Brexit continues to make the BoE more cautious than otherwise. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: House prices contracted at a quarterly pace by 0.2%, less than the expected 0.5%; NAB Business Confidence went down from 9 to 6; NAB Business Conditions went down from 21 to 12; Westpac consumer confidence went up to 3.6% from -1.7%; However, employment increased by 61,600, beating expectations of 18,000, with full-time employment increasing by 41,900, outperforming part-time employment of 19,700; The AUD rallied on these data releases. Furthermore, faltering U.S. inflation and upbeat Chinese data fed into the AUD's rally. The Australian economy is still mired in substantial slack, and the RBA is likely to stay easy, putting a lid on AUD upside. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Seasonally-adjusted building permits contracted by 9.6% in October. Furthermore, the terms of trade index, continued to fall in the third quarters, coming in at 0.7%. This number also surprised to the downside. Manufacturing sales grew by 0.3% in the third quarter, a slowdown from the 1% growth witnessed in Q2. Finally, the ANZ Business Confidence measure fell to -39.3, the lowest level in more than 9 years. The NZD/USD has rallied by roughly 3% in the past week. This mostly reflects weakness on the part of the USD yesterday following the FOMC interest rate decision as NZD is flat against the AUD on the weak. Overall, the long term outlook for NZD/USD, NZD/EUR, and NZD/JPY is negative, as decreased immigration and the addition of an employment mandate for the RBNZ, will structurally lower rates in New Zealand. However, NZD still possesses upside against the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Last week, the BoC left its policy rate unchanged at 1%. The Bank is delaying hiking as inflation and growth have slowed. The BoC also want to appraise the impact of its previous two interest rate hikes as well as the brewing risks surrounding NAFTA negotiations. That being said, inflation still is around 40 bps higher than it was in June. Employment data remains stellar, and the tightening labor market is pointing to a pickup in wages. Additionally, oil could offer additional upside as supply continues to be curtailed by Saudi Arabia and Russia. The CAD is likely to perform well next year, particularly against the SEK and the AUD. However, upside against the U.S. dollar will be limited. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation surprised to the downside, coming in at 0.8%. However it increased from 0.7% on the previous month. The unemployment rate came in below expectations, at 3%. Additionally, the SNB kept its -0.75% deposit rate unchanged. Furthermore, it continued to signal that it will stay active in the foreign exchange markets. Indeed, the SNB stated that although the overvaluation of the franc has decreased "the franc remains highly valued". On a more positive note, however, the SNB revised its inflation forecast for its coming quarters, suggesting an overshoot may even happen and be tolerated as this inflation upgrade mainly reflected the appreciation of oil and the depreciation of the franc. We continues to believe that the SNB will keep its ultra-dovish monetary policy in place as long as core inflation remains very low and the Swiss franc stays overvalued on a PPP basis. These negatives for the franc could get occasionally interrupted when volatility re-emerges global markets. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Core inflation surprised to the downside, coming in at 1.1%. This number also declined from last week's number of 1.2%. Retail Sales growth also underperformed expectations, coming in at -0.2%. However this number improved from last month's 0.8% contraction. However manufacturing output outperformed expectations, coming in at 0.7%. However this number slowed down from last month's 2.8% growth. The Norges Bank kept rates unchanged at 0.5% at its latest monetary policy meeting. Overall, this release was less dovish than markets expected as the Norge Bank brought forward to late 2018 it expectations for a first hike. Essentially, despite a weak batch of data this week, the Norwegian economy is heeling, and is not experiencing the same debilitating deflationary pressures as has been experienced by other countries in Europe. Our favored way to play these improvements in the Norwegian economy, along with the change of tone at the Norges Bank helm is to buy NOK/SEK And short EUR/NOK. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data has recently taken a stronger turn: Industrial production increased by 6% annually, higher than the previous 2.7% growth rate; Manufacturing new orders increased by 3.8% annually; Inflation popped up to 1.9%, higher than the previous 1.7%, and outperforming the expected 1.7%. While inflation has picked back up, last quarter's disappointing GDP numbers still raises important question marks. The risks are still skewed toward the current Riksbank leadership maintaining a dovish stance, despite an economy that hardly needs it. This risk will only grow if our EM canaries are correct and global industrial activity turns around, a phenomenon that will impact Swedish growth and inflation negatively. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Global growth will remain strong in 2018, but the composition of that growth will shift in favour of the U.S. The surprise results of the Alabama Senate election are unlikely to scuttle the Republicans' tax plans. We expect a bill to be finalized by the end of the year. The Fed is poised to raise rates four times next year, two more hikes than the market is pricing in. The dollar should stage a modest rebound in 2018. China's economy will decelerate over the coming months, but merely from an above-trend pace. Near-term concerns about Chinese debt levels are overblown. Stay cyclically overweight global risk assets at least for the next six months. Feature Tax Cut Or Not, U.S. Growth Is Likely To Stay Strong In 2018 We expect global growth to remain strong in 2018. However, the composition of that growth is likely to shift back towards the United States. The weakening of the dollar this year should boost net exports, while dwindling spare capacity and faster wage growth should spur business investment and consumer spending. A looser fiscal policy will also help buoy the U.S. economy, but as we have discussed in recent reports, the contribution to growth from lower tax rates is likely to be fairly modest.1 We estimate that the final bill will lift real GDP growth by about 0.2%-0.3% in 2018 and 2019. The effects will diminish thereafter, eventually turning negative as larger budget deficits crowd out the savings that are necessary to finance private-sector investment. Democrat Doug Jones' surprise victory in the Alabama Senate election has thrown a wrench into the legislative process. Outgoing Senator Bob Corker voted against the original bill. If the reconciled House and Senate bill is not passed by the time Jones is seated in January, the Republicans may not have enough votes to get it through the chamber. Our geopolitical strategists expect the bill to pass by the end of the year, but this will likely require that Congressional Republicans acquiesce to Senator Collins' demand that Congress adopt legislation to help health insurers deal with the proposed abolition of the individual mandate. It may also require that Republican dealmakers ditch their last-minute effort to cut the marginal personal tax rate to 37% (the House version of the bill penciled in a top rate of 39.6%, while the Senate version envisioned a rate of 38.5%). The Fed Keeps On Hiking The Federal Reserve hiked rates again this week, taking the fed funds target range up to 1.25%-1.50%. The Fed's determination to tighten monetary policy at a time when inflation is still below target has many investors fretting. We are not particularly concerned. Inflation is a highly lagging indicator. The New York Fed's Underlying Inflation Gauge, which includes various forward-looking inflation components such as producer prices and the ISM prices paid index, has accelerated to a cycle high of 3.0% (Chart 1). The unemployment rate is likely to fall to 3.5% by the end of next year. This would leave it more than one full point below NAIRU and 0.4 points below the median dot in the Summary Of Economic Projections released on Wednesday. Auxiliary measures of labor market slack, such as the U-6 rate and the share of the working-age population that is out of the labor force but wants a job, have also fallen back to pre-recession levels (Chart 2). Chart 1U.S. Inflationary Pressures Starting To Brew Chart 2Labor Market Slack Has Largely Vanished If U.S. growth surprises on the upside next year, as we expect, the Fed is likely to raise rates four times in 2018. This is roughly two more hikes than the market is currently pricing in. We recommended shorting the December 2018 fed funds futures contract on September 7th. The trade is up 48 basis points since then, but we think there is still scope for further gains. Modestly Slower Growth Elsewhere Outside the U.S., growth is likely to come down a notch in 2018. Japanese growth should cool somewhat from the heady pace of 2.7% seen over the past two quarters. Euro area growth is also likely to tick lower, as the impact of a stronger euro begins to bite. Financial conditions in the U.S. have loosened significantly relative to those in the euro area since the start of 2017. If history is any guide, this will cause euro area inflation to rise less than U.S. inflation over the coming year (Chart 3). This, in turn, will keep the ECB's forward guidance on the dovish side. This week's ECB meeting reinforced the message that the central bank is unlikely to raise rates at least until the summer of 2019. Chart 3Diverging Financial Conditions Will Have Inflationary Consequences Chart 4 shows that the euro has strengthened more against the dollar since the beginning of this year than can be accounted for by changes in interest rate expectations. We expect EUR/USD to fall back to 1.11 by the end of 2018. Chart 4AEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials Chart 4BEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials The Chinese Wildcard The biggest question mark over growth surrounds China. Real-time measures of industrial activity such as electricity generation, freight traffic, and excavator sales have slowed since the start of the year (Chart 5). The Caixin manufacturing PMI has also dipped, signaling weaker growth prospects among the country's small-to-medium sized private enterprises. Monetary conditions have tightened (Chart 6). How worried should investors be? So far, there is no reason to panic. Growth has weakened, but from an above-trend pace. Nominal GDP growth reached 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation rose to 6.9% in October before backing off to 5.8% in November. Some cooling in the economy was both inevitable and desirable (Chart 7). Chart 5Growth Has Ticked Down ##br##Modestly In China Chart 6Monetary Conditions Have##br## Tightened In China Chart 7Chinese Growth Has Merely Weakened##br## From An Above-Trend Pace A more ominous slowdown cannot be ruled out, but that would require a substantial policy error. Such errors have occurred in the past. In 2015, the government undertook measures to reduce credit growth and cool the property market just as the global manufacturing sector was entering a recession on the heels of a sudden decline in energy sector capex. The Chinese authorities amplified the problem by trying to tippy-toe over the question of whether to devalue the currency, even as other EM currencies were sinking. This led to large capital outflows, thereby exacerbating the tightening in Chinese financial conditions. The circumstances today are quite different from 2015. While the authorities have clearly stepped up the pace of reforms following the Party Congress, the global and domestic backdrop is a lot more favorable. Global growth is much stronger. The yuan is also a lot cheaper - down 8.8% in real trade-weighted terms since its peak in 2015 (Chart 8). Chart 8The Yuan Has Cheapened Since 2015 Domestic demand remains on a firm footing. The service sector PMI ticked up further in November, an important development considering that China's service sector is now larger than its manufacturing sector (Chart 9). Alibaba reported sales of over U.S. $25 billion on its platform on "Singles Day" last month, up 39% from last year, and greater than U.S. online sales on Black Friday and Cyber Monday combined. The Chinese government is unlikely to take measures that allow growth to fall significantly below trend. Indeed, if anything, the recent evidence suggests that the authorities are tentatively easing their foot off the brake. Bond yields and credit spreads have come off their recent highs. New loans to the real economy clocked in at RMB 1.12 trillion in November, well above consensus estimates of RMB 800 billion. While the year-over-year change in M2 growth remains close to historic lows, the three-month change has hooked up (Chart 10). Chart 9It's Not All About Manufacturing In China Chart 10China: Money Growth Starting To Accelerate Higher core inflation has pushed real deposit rates into negative territory, making it increasingly painful for households to hold cash. This should cause the velocity of money to speed up, allowing nominal GDP growth to exceed money growth. Don't Bet On A Chinese Debt Crisis... Yet What about the longer-term debt issues haunting China? Here, there is both good and bad news. The bad news is that China's need to keep piling on debt may be an even more vexing problem than typically assumed. Pundits often claim that the government simply needs to bite the bullet and take the painful measures that are necessary to curb debt growth. The problem with this argument is that it sidesteps the question of what will offset the loss in spending from slower debt accumulation. Chinese households are massive net savers (Chart 11). As a matter of arithmetic, these savings must either be transformed into domestic investment or exported abroad via a current account surplus. China used to emphasize the latter. Its current account surplus reached 10% of GDP in 2007, mainly due to a widening trade surplus. It would be economically and politically impossible to pursue such a beggar-thy-neighbour strategy today. Economically, China is simply too big. Its economy has more than doubled relative to the rest of the world over the past decade (Chart 12). Politically, no major economy these days is prepared to tolerate a massive trade deficit with China - certainly not the U.S. Chart 11Mattresses Are ##br##Thicker In China Chart 12China's Size Limits Its Ability To Export Its ##br##Way Out Of Its Problems This means that China must now recycle excess savings internally. One way that Chinese households have done this is by purchasing real estate. In many respects, the Chinese property market has served as a piggy bank of sorts for much of the population. Large amounts of savings have also been placed into bank deposits and, increasingly, so-called wealth management products. These funds have then been used to satisfy the borrowing needs of local governments and business enterprises. It is no surprise that credit growth in China began to accelerate in 2009, just as the current account surplus was starting to narrow (Chart 13). In practice, the distinction between fiscal and corporate spending in China is rather blurry. Chart 14 shows China's official general government budget deficit as well as an augmented version constructed by the IMF which includes various off-balance sheet expenses. The former stands at a reasonably slim 3.7% of GDP, while the latter weighs in at a hefty 12.6% of GDP. Chart 13Credit Growth Took Off As ##br##Current Account Surplus Shrunk Chart 14China's "Secret" ##br##Budget Deficit A large chunk of these off-balance sheet items consist of losses incurred by China's state-owned enterprises. In many respects, these companies are the equivalent of Japan's fabled "bridges to nowhere": They exist to prop up demand in an economy where there is too much savings. Rather than making the economy more efficient, the risk is that structural reforms, if undertaken too rapidly, will simply depress growth. The most misallocated resource is a worker who wants a job but cannot find one. The troubling implication is that deleveraging may be difficult to achieve without causing significant economic distress. On The Bright Side... Fortunately, a number of factors mitigate the risks of a Chinese debt crisis. As Japan's experience shows, as long as a country has ample domestic savings and borrows primarily in its own currency, debt can increase to levels that many people might have thought impossible. Moreover, most of China's debt mountain consists of loans made by state-owned banks to SOEs and local governments. These loans often carry implicit guarantees from the central government. While this exacerbates the moral hazard problem, it does limit the potential of "leveraged losses" to lead to a massive credit crunch of the sort experienced during the Global Financial Crisis. China also has reasonably good long-term growth prospects. Output-per-worker is only a quarter of U.S. levels. Likewise, capital-per-worker is a fraction of what it is among advanced economies (Chart 15). Even with its bleak demographics, China would need to grow by around 6% per year over the coming decade if it were to remain on course to catch up to South Korea in output-per-worker by 2050 (Chart 16). Chart 15China Has More Catching Up To Do (1) Chart 16China Has More Catching Up To Do (2) Given China's well-educated labor force, it is likely that productivity levels will continue to converge with richer economies in the years ahead (Chart 17). Rapid growth, in turn, will allow China to outgrow some its debt and overcapacity problems more easily than would be the case for slower growing economies. Chart 17A Well-Educated Labor Force Bodes Well For China's Development Lastly, not all credit creation in China represents the intermediation of savings into productive investment. A lot of it is simply driven by speculative activities that contribute little to growth. Curbing the ability of individuals and companies to use extreme amounts of leverage to supercharge financial returns would enhance economic stability. To its credit, the government is actively addressing this issue. The bottom line is that Chinese growth is likely to slow modestly next year, but not by enough to imperil the global economy. Investors should remain cyclically overweight global equities and other risk assets at least for the next six months. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017; and Weekly Report, "Fiscal Follies," dated November 17, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades