Monetary
Highlights Chinese growth will slow next year, but underlying momentum remains strong. Jerome Powell is the most likely choice for Fed chair. However, no matter who is selected, the general thrust of monetary policy will not change radically next year. The transatlantic interest rate spread is not particularly wide considering that the output gap is larger in the euro area, while the neutral rate and expected inflation are lower. U.S. growth should surprise on the upside over the next few quarters, as already evidenced by the rebound in the economic surprise index. This will give the Fed greater scope to raise rates. We expect EUR/USD to reach $1.15 by the end of the year. Feature China: Let's Get This Party Congress Started China's 19th National Congress of the Communist Party of China kicked off this week. As widely expected, President Xi Jinping lauded the successes that China has enjoyed over the past few years in his opening speech, but cautioned that more must be done to reduce corruption, clean up the environment, and expedite market reforms.1 We expect Chinese growth to slow modestly in 2018 from the current above-trend pace, as the government pares back stimulus efforts. Nevertheless, the underlying trend in growth will remain reasonably solid. Chart 1 shows that real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at a healthy pace. Despite the introduction of some tightening measures this spring, the housing market remains resilient. The share of households planning to buy a new home is close to record high levels, while the amount of land purchased by developers - a good leading indicator for housing starts - has continued to accelerate (Chart 2). Chinese property developer stocks have been on a tear this year, outperforming even the red-hot tech sector. With housing inventory levels at multi-year lows, home prices should stay firm. In the industrial sector, rampant producer price deflation last year has given way to modest inflation this year. This has boosted industrial profits, which should support corporate spending in the months ahead (Chart 3). Chart 1Chinese Economy: No Need To Be Pessimistic Chart 2Chinese Housing Market Remains Resilient Chart 3Boost In Industrial Profits Bodes Well For Corporate Spending Both money and credit growth surprised on the upside in September. As we have argued before, copious private-sector savings will forestall a credit crunch and, at least for the foreseeable future, permit the government to run large off-balance sheet budget deficits in an effort to support aggregate demand (Chart 4). Indeed, for all the talk about slowing credit growth, medium- and long-term bank lending to nonfinancial corporations - probably the best single measure of credit flows to the real economy - has continued to accelerate this year (Chart 5). Investors should continue to overweight Chinese stocks relative to the EM aggregate. Chart 4China's Fiscal Deficit Has Been Increasing Chart 5Credit To Real Economy Accelerating Musical (Fed) Chairs News reports indicate that President Trump has winnowed down the list of candidates for Fed chair to five individuals: Chief economic advisor Gary Cohn, current Fed Governor Jerome Powell, former governor Kevin Warsh, Stanford university economist John Taylor, and current chair Janet Yellen. We suspect that Cohn will not make the cut, given his apparent falling out with Trump following the President's remarks about the Charlottesville protests. Warsh and Taylor are likely to be seen as too hawkish. That just leaves Powell and Yellen. Chair Yellen's relatively dovish views on monetary policy would likely sit well with Trump, but she has two major strikes against her. One, she has generally been in favor of more financial sector regulation, which is anathema to Trump. Two, Trump accused her of abetting Hillary Clinton during the election campaign. Keeping her as Fed Chair (assuming she would actually want the job) might convey the message that he is no longer interested in shaking up the existing institutional order in Washington DC. This just leaves Powell as the default candidate, who reportedly has received the blessing of Treasury Secretary Steven Mnuchin. The prevailing wisdom is that Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. Such a potentially malleable mind may be exactly what Trump is seeking! Still, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. Thoughts On The Transatlantic Yield Spread I have been visiting clients in Europe this week and questions about the relative stance of monetary policy between the U.S. and the euro area have come up in almost every meeting. The gap between U.S. and euro area rate expectations has narrowed since the start of the year, helping to push the euro higher. Nevertheless, most interest rate spreads remain elevated by historic standards. This has led many commentators to speculate that they will continue to shrink, putting further upward pressure on EUR/USD. For example, the U.S. 5-year Overnight Index Swap rate currently stands at 1.82%. This compares to only 0.02% in the euro area. The current level of spreads can be partly explained by the fact that labor market slack is still substantially higher in the euro area than in the U.S. Outside of Germany, labor underutilization is still 6.3 percentage points higher across the euro area than in 2008 (Chart 6). In contrast, our work suggests that the U.S. labor market has returned to full employment.2 Chart 6Euro Area: Labor Market Slack Still High Outside Of Germany This is not to say that transatlantic interest rate spreads won't narrow over the coming years. They will. But what matters for investors is how spreads evolve relative to market expectations. The market is already pricing in roughly 50 basis points of spread compression in five-year rates between now and 2022. If one looks further out to 2027, the spread in expected policy rates stands at 94 basis points.3 That may still seem like a lot, but keep in mind that inflation expectations in the euro area are well below those of the U.S. The CPI swap market is predicting that U.S. inflation will exceed euro area inflation by 67 basis points over the next decade. All things equal, lower inflation in the euro area implies that nominal interest rates should be lower there too. Moreover, many euro area government bond markets trade at a discount due to country-specific default/denomination risks. While these risks have faded, they have not gone away. As such, GDP-weighted euro area government bond yields - which are arguably what the ECB cares most about - are generally higher than swap rates of the same maturity. In Search Of Fair Value Chart 7The Neutral Rate Is Lower In The Euro Area A reasonable estimate is that the market currently sees the real terminal rate in the U.S. as being roughly 40 basis points higher than in the euro area. As it happens, this is almost identical to the gap in the neutral rate between the two regions that Williams, Laubach, and Holston have calculated (Chart 7). Does that mean that the current transatlantic spread is close to fair value? Not quite. One of things that has become apparent over the past eight years is that euro area membership comes at a high price. When countries such as Italy and Spain are hit by adverse economic shocks, they are limited in how they can respond. They cannot devalue their currency because they do not have a currency to devalue; and they cannot loosen fiscal policy for fear of being attacked by the bond vigilantes. All they can do is suffer from grinding deflation in the hopes of regaining competitiveness through weak wage growth. This means that over the long haul, unemployment in the euro area is likely to be above NAIRU more often than in the U.S. This, in turn, implies that euro area policy rates will, on average, be below their neutral value more often than in the U.S. Thus, even if the gap in the real neutral rate between the two regions were 40 basis points, the expected gap in policy rates should be larger than that. Modest Downside For EUR/USD The discussion above suggests that the transatlantic interest rate spread is not especially wide if one looks further out in time. If U.S. growth surprises on the upside over the coming months, while euro area growth flatlines, spreads will widen again. Such an outcome is, in fact, quite likely. U.S. financial conditions have eased significantly relative to those of the euro area since the start of the year (Chart 8). To the extent that changes in financial conditions lead growth by about 6-to-9 months, the U.S. could start outperforming the euro area as we enter 2018. The fact the Goldman's Sachs' U.S. Current Activity Indicator has hooked higher and the economic surprise index has rebounded smartly is early evidence that this process may have already begun (Chart 9). We see EUR/USD falling to 1.15 by the end of the year. Chart 8Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Chart 9Early Evidence That U.S. May ##br##Outperform Euro Area Next Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy / China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017. 2 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 3 We estimate the expected policy rates ten years out by looking at one-month, 10-year forward OIS rates (i.e., the market's expectation of where one-month OIS rates will be ten years from today). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Chart I-2... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? Chart I-17Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 Chart II-2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 The Euro Chart II-3 Chart II-4 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5 Chart II-6 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7 Chart II-8 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9 Chart II-10 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11 Chart II-12 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13 Chart II-14 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15 Chart II-16 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17 Chart II-18 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19 Chart II-20 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Portfolio Strategy Go long industrials/short discretionary. Leading indicators of interest rates, relative sentiment, relative demand and relative exports all signal that industrials stocks will outperform their consumer discretionary peers. A price war is gripping airlines anew, and it will suck the air out of the industry. Recent Changes Long S&P Industrials/Short S&P Consumer Discretionary - Initiate this pair trade today. Table 1 Feature Tax relief euphoria propelled the S&P 500 to fresh all-time highs last week. While such exuberance has rekindled the "Trump trade" with small caps outshining mega caps and banks soaring (as a reminder we have a small cap size bias and are overweight financials/banks1), it will likely prove fleeting unless the tax bill becomes law. BCA's Geopolitical Strategy service believes that a tax bill passage is likely in Q1/2018.2 Were that to materialize, it would serve as a catalyst to further fuel the blow off phase in equities. Why? Empirical evidence suggests that easy fiscal policy outweighs the drag from Fed interest rate tightening. Filtering the post WWII era for periods of easing fiscal and tightening monetary policies during expansions is revealing. We define easy fiscal policy as increasing fiscal thrust (year-over-year change in cyclically-adjusted fiscal balance as a percentage of potential GDP, shown inverted, bottom panel, Chart 1) and tight monetary policy as a rising fed funds rate. Chart 1Easy Fiscal + Tight Money = Buy SPX While this is a rare occurrence, it has clearly happened seven times since the mid-1950s (shaded areas, Chart 1). As a clarification, we omitted the brief periods in the early-1960s, early-1970s and twice in the early-1980s as they were very close to the end of those recessions and positively skewed the results. All iterations resulted in positive stock returns with the SPX rising on average by over 16%. Table 2 details all seven periods that have an average duration of 16 months. There are high odds that a tax bill enactment coupled with a potential infrastructure spending bill will more than cushion the blow from the Fed's interest rate hikes in 2018, and sustain the overshoot phase in equities. As we recently showed in our equity market indicator White Paper, the business cycle stays intact during Fed tightening cycles, and historically a peak in the fed funds rate presages a recession.3 Importantly, the highly cyclical part of the U.S. economy is humming. The latest ISM manufacturing survey showed that new orders are running 20% higher than inventories, with the headline number soaring to a 13 year high (third panel, Chart 2). Prices paid also spiked to above 70, signaling that commodity inflation is looming. And, were the capex revival to gain steam as most of the leading indicators we track suggest (see Chart 8 from the October 2nd Weekly Report), then late cyclicals will continue to benefit from end-demand resurgence. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 2It's Deep##br## Cyclicals' Time As a result, we reiterate last week's upgrade of the S&P industrials sector to overweight, and this week we add more deep cyclical exposure to our portfolio by initiating a market-neutral pair trade to benefit from this enticing macro backdrop. Industrials Will Outmuscle Consumer Discretionary In the past few weeks, we have tweaked our cyclical portfolio exposure by downgrading early-cyclical consumer discretionary stocks to a benchmark allocation and lifting the late cyclical industrials complex to overweight. In fact, a once-in-a-generation opportunity to buy industrials at the expense of discretionary stocks has surfaced, and we recommend a new long S&P industrials/short S&P consumer discretionary sector pair trade to exploit this tradable opportunity. Chart 3 shows that relative share prices recently bounced near the early-1970s all-time lows and a mini V-shaped recovery is taking root. The industrials/discretionary price ratio has been in a downtrend for the better part of the past decade and the most recent peak-to-trough collapse has been a 4 standard deviation move (Chart 3). Even a modest relative performance renormalization near the historical mean would translate into impressive returns. Chart 3Compelling Entry Point Four key drivers underpin our warming up to this late over early cyclical pair trade: interest rates, relative sentiment, relative demand and relative export backdrop. The Fed embarked on a fresh tightening interest rate cycle almost two years ago and is on track to lift the fed funds rate another 100bps by the end of 2018 according to the FOMC's median dot forecast. Interest rate-sensitive stocks suffer when the Fed tightens monetary policy, whereas deep cyclicals disproportionately benefit from accelerating economic growth. Chart 4 confirms that over the past four decades a rising fed funds rate has been synonymous with an increase in the relative share price ratio and vice versa. Chart 4Tight Money Is Good For Industrials But Weighs On Discretionary The framework we use on the interest rate front is that higher interest rates represent a sizable hindrance to consumer spending (top and second panel Chart 5). Not only does the price of housing-related credit rise in lockstep with fed hikes, but also auto and credit card interest rates, two major consumer loan categories, increase on the back of the Fed's tighter monetary backdrop. True, C&I loan pricing also suffers a setback, but capital goods producers can bypass banks and raise debt in the bond markets. In fact, this cycle, the global hunt for yield and unconventional monetary policies have suppressed interest rates to the benefit of corporate borrowers. One final relative advantage industrials outfits have this cycle is rising pricing power in the form of firming commodity prices (third panel, Chart 5), while wage growth/median income (a proxy for consumer pricing power) has been subpar. Taken together, higher interest rates and rising commodity prices should continue to underpin relative share price momentum (Chart 5). Relative sentiment readings also suggest that industrials manufacturers have the upper hand versus consumer discretionary companies (Chart 6). The overall ISM manufacturing survey is easily outpacing consumer confidence readings. Importantly, the ISM survey and most of the subcomponents are making multi-year highs, while both the University of Michigan's consumer sentiment survey and The Conference Board's consumer confidence reading peaked in early 2017. Chart 5Commodity Inflation Is A Boon For##br## Industrials But Bane For Discretionary Chart 6Manufacturing Flexing ##br##Its Muscles With regard to the relative demand landscape, a sustained capital expenditure upcycle is promising for capital goods producers (second panel, Chart 7), at a time when personal consumption expenditures (PCE) are anemic at best. Notably, real capital outlays have been rising at a faster clip than real PCE, signaling that the upward trajectory in relative forward EPS estimates is sustainable (middle panel, Chart 7). Our relative pricing power gauge has recently come out of its funk reflecting this improving relative demand backdrop. The implication is that a rerating phase is likely in the coming months (bottom panel, Chart 7). Finally, the relative export backdrop suggests that industrials come out on top of discretionary stocks (top panel, Chart 8). According to FactSet the S&P consumer discretionary sector's foreign revenue exposure stands at 24% of total sales, and it is roughly 60% higher for the S&P industrials sector at 38% of revenues.4 While the year-to-date breakdown in the greenback is stimulative for industrials exporters, it is, at the margin, restrictive for the more domestically oriented consumer discretionary companies (trade-weighted dollar shown inverted, bottom panel, Chart 8). Our relative EPS growth models best capture all of these moving parts and suggest that the path of least resistance for relative profit growth is higher in the coming quarters (Chart 9). Chart 7Capex##br## Upcycle... Chart 8... And Export Markets Benefit Industrials##br## At The Expense Of Discretionary Chart 9Relative Profit Growth Models Also Say##br## Buy The Relative Share Price Ratio Adding up, all four key macro variables (interest rates, relative sentiment, relative demand and relative export exposure) signal that the time is ripe for a new industrials versus discretionary pair trade. Bottom Line: Initiate a long S&P industrials/short S&P consumer discretionary sector pair trade. Airlines Update: Mayday While we have turned positive on the broad industrials complex and remain constructive on most transports, we continue to recommend investors avoid the S&P airlines index. This decade has seen a huge recovery in consumer confidence, rising from the depths of the Great Recession. The consumer's revival has been matched by equally steep growth in airline passenger traffic (Chart 10). However, the resurgence in passenger demand has not had the expected uplift in pricing. Rather, the opposite has happened; consumers have not seen a sustainable price increase in years and airline pricing power has collapsed, even in the face of soaring jet fuel costs that eat into profits (Chart 11). The costly price war between the low cost carriers and the largely-restructured legacy airlines the industry is currently embroiled in explains deflating airfares (Chart 12). Chart 10More Passengers... Chart 11... But Higher Fuel Costs... Chart 12... And Price Concessions Crash Profits The industry has been here before, and recently too. 2015 was a tumultuous year that saw pricing collapse as the ultra-low cost carriers entered the traditional hubs, triggering a scramble for market share. Brave airline investors have been whipsawed as the industry recovered and then stumbled again earlier this year. From a profit perspective, airlines have been able to hide poor pricing with efficiency gains (Chart 13). Industry load factors have been steadily moving upward, though those gains appear to have plateaued at peak levels. The implication is that this current price war will hit profit margins and thus the bottom line worse than in the past (Chart 13). Expanding international air travel could provide some relief to the besieged legacy carriers as international airfares look to have pulled out of deflation (Chart 14). However, the sustainability of positive pricing is questionable as international no-frills carriers are gaining greater penetration and often have significantly lower cost structures. Once unheard of trans-Atlantic travel for below $200 is now widely available. Chart 13Masking Poor Pricing Backdrop Chart 14Analysts Ignore Positives At the same time as cash generation appears most threatened, the industry is in the midst of an expensive fleet renewal as airlines seek to replace declining prices and aging fleets with higher volume and more efficient aircraft. In fact, capex as a percentage of sales has nearly tripled since 2012. The result is predictable; the hard deleveraging work the industry put in over the course of this decade is being unwound (Chart 13). An increasingly geared balance sheet, combined with weakening margins should translate directly into a higher risk premium and lower valuation multiples. However, while multiples have fallen from the sky-high levels earlier this decade, they remain well above the lows of 2015-16 (Chart 14). This implies further downside risk should risk premiums expand as we expect. With sell-side analysts jumping on board the bear story, as evidenced by net forward earnings revisions falling off a cliff (Chart 14), this should probably happen sooner rather than later. Bottom Line: With no end in sight to the price war and outsized capacity additions likely to throw fuel on the fire, we think investors should stay away from the S&P airlines index. Accordingly, we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report,"Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 Please see Chart 55 of BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)", dated August 7, 2017, available at uses.bcaresearch.com. 4 https://www.factset.com/earningsinsight Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.