BCA Indicators/Model
Highlights U.S. Treasuries: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in U.S. inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. Canada: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds and stay long inflation protection (both through linkers and CPI swaps). 2017 Model Portfolio Performance Wrap-Up: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps of underperformance versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Feature Chart of the WeekGlobal Bond Yields Are Too Low 2018 has started much as 2017 ended, with growth-sensitive assets rallying alongside robust economic data. Most major global equity markets are already up 2-3% after the first week of the year, with the U.S. NASDAQ, Japanese Nikkei and Italian MIB indices advancing over 4%. Global credit markets are also off to a strong start, with spreads for U.S. High-Yield corporate debt and EM hard currency corporate debt tighter by -17bps and -8bps, respectively. Even commodity markets have joined the party, with the benchmark Brent oil price hitting the highest level in nearly three years. The pro-growth, pro-risk backdrop is keeping upward pressure on global government bond yields. This is occurring primarily through the inflation expectations component of yields, which are rising in all developed economies (even Japan). Real yields, which are not rising despite the strength of the broad-based global growth upturn (Chart of the Week), have been drifting lower, providing some offset to rising inflation expectations. The primary trend for global yields remains upward, however - especially if growth remains solid and inflation expectations continue to push higher, giving central banks like the U.S. Federal Reserve the confidence to continue hiking interest rates. We continue to favor below-benchmark duration exposure, and overweight corporate bond allocations versus government debt, for global fixed income investors over the next 6-9 months. U.S. Treasuries: Still More Reasons To Sell Than Buy U.S. Treasury market participants have a lot to things to be nervous about at the moment. Likely future Fed rate hikes, the weakening U.S. dollar, rising oil prices, ongoing U.S. labor market strength, persistently booming economic growth, the never-ending equity bull market, the potential impact of the Trump fiscal stimulus, the Fed starting its balance sheet runoff - all factors that should force bond investors to expect yields to rise. Yet longer-dated Treasury yields continue to trade too low relative to the bond-bearish fundamentals. The current benchmark 10-year Treasury yield at 2.48% remains well below the fair value from our 2-factor regression model, which is now up to 2.94% (Chart 2). That valuation gap of 46bps is close to the widest levels seen in July 2016 and September 2017, which were both episodes that proved to be excellent entry points for bearish Treasury positions. The two inputs into our Treasury yield model are the global manufacturing PMI and bullish sentiment towards the U.S. dollar (USD). The PMI is included as an indicator of global growth and currently sits at 54.5 - the highest level in nearly seven years - led by strong readings in almost every major economy (Chart 3). This has been the primary driver of the fair value for the 10-year Treasury yield since global growth bottomed out and began to accelerate in mid-2016. Chart 210-Year Treasuries Are##BR##Overvalued On Our Model Chart 3Global Growth##BR##Is Booming Sentiment towards the USD is the second input to our Treasury model. It is included as a weakening greenback represents an easing of monetary conditions that could trigger a need for more Fed rate hikes that can push the Treasury curve higher from the short-end (and vice versa for a rallying USD). At the same time, a depreciating USD can drive U.S. inflation higher through higher costs of imported goods & services, which can raise bond yields through higher inflation expectations or greater Fed tightening expectations (again, the opposite holds true for a strengthening USD). Right now, both the strong PMI and weak sentiment towards the dollar are boosting the fair value of the 10-year Treasury yield. The fall in value of the greenback is particularly unusual, as it is flying in the face of widening interest rate differentials between the U.S. and the rest of the world (Chart 4, top panel). This is clearly a function of the fact that global growth is rapidly improving - especially in Europe - but very few central banks have yet to respond to that growth with interest rate hikes that match what the Fed has been delivering. So while actual interest rate differentials remain USD-supportive, expectations of some eventual tighter monetary policy outside the U.S. that could narrow those interest rate gaps are triggering speculative inflows into non-USD currencies. With the trade-weighted USD now 5% below levels of a year ago, this should lead to higher headline inflation in the U.S. in the next few months (middle panel). Combined with the continued strength in global oil prices, that means that the two biggest factors that weighed on realized U.S. inflation- the USD rally and oil price collapse of 2014/15 - are now both acting to boost inflation expectations (bottom panel). Throw in the growing body of evidence that a tight U.S. labor market that is putting gentle upward pressure on wage growth, and U.S. inflation expectations - which still remain 40-50bps below levels consistent with the Fed's inflation target - should continue to move higher in the next six months. Rising longer-term inflation expectations would typically result in bear-steepening pressures on the Treasury yield curve. That is not happening at the moment, however, with the 2-year/10-year Treasury curve still at a relatively flat 53bps at the time this report went to press. The flatness of the Treasury curve has worried investors, and even some Fed officials, given the well-known leading relationship between the yield curve and U.S. economic growth. It is too early to draw any conclusions between the shape of the curve and future U.S. economic growth, however, for several reasons: As mentioned above, inflation expectations are still well below levels consistent with the Fed's 2% inflation target on the PCE deflator (which translates to 2.5% on the CPI index used to price TIPS and CPI swaps). Both the European Central Bank (ECB) and Bank of Japan (BoJ) are still buying bonds through their asset purchase programs, although at a slower pace than previous years. This continues to depress local bond yields in Europe and Japan with spillover effects into the U.S. Treasury market - even as the Fed begins the slow runoff of Treasuries from its massive balance sheet. Data on mutual fund and ETF flows shows that there has been significant and sustained buying of bond funds by U.S. retail investors over the past couple of months. There has also been net selling of equity funds, however, suggesting that U.S. retail investors are rebalancing as the equity markets surge higher. Investor positioning in the U.S. Treasury market is very short at the moment, with the J.P. Morgan survey of "active" bond manager duration exposure at an all-time low and the net positioning on Treasury futures now slightly favoring shorts (Chart 5). It makes little sense to interpret a flattening Treasury curve as a signal that the bond market believes that the Fed was making a policy mistake if professional bond investors were running massive duration underweight positions that would benefit if bond yields rise. Chart 4Upside Pressure On U.S. Inflation##BR##From Oil & The USD Chart 5Big Duration Underweight##BR##Among U.S. Bond Managers All these factors muddy the economic signal provided by the Treasury curve at the moment. Nonetheless, we remain of the view that the Fed would not continue on its rate hiking path without U.S. inflation expectations moving sustainably back to levels consistent with the Fed's inflation target. In other words, the Treasury curve must bearishly steepen first through rising inflation expectations before bearishly flattening later through actual Fed rate hikes. The latter will dampen future U.S. growth expectations and eventually result in a cyclical peak in longer-dated Treasury yields, but from levels closer to 3% on the 10-year after inflation expectations "fully" normalize. Bottom Line: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. The Bank Of Canada Keeps On Playing Catch-Up The Canadian economic story continues to be the best within the developed world. The year-over-year growth rate for real GDP accelerated to over 3% late last year, primarily on the back of robust consumer spending (Chart 6). Even the lagging parts of the economy, like business investment and government spending, began to perk up last year. The momentum remained powerful at the end of 2017, with the unemployment rate in December hitting a 40-year low. The economic boom forced the Bank of Canada (BoC) to begin lifting interest rates last year, with two 25bp hikes occurring in July and September that unwound the easing from 2015. The rapid pace of growth has absorbed spare capacity much faster than the BoC originally projected. More hikes will be required if the current pace of growth is maintained, particularly with the BoC estimating that the neutral policy rate is around 3% and the current Overnight Rate is only at 1%. The Canadian consumer has been enjoying a powerful shopping spree. Real consumer spending growth is at 4% on a year-over-year basis - the highest level since early 2008 (Chart 7). This is led by a powerful surge in spending on consumer durables, where annual growth has surged to 10% (middle panel). Consumer confidence is booming and Canadian workers are enjoying the fastest pace of income growth since 2014 (bottom panel). Chart 6Robust Canadian Growth,##BR##Led By The Consumer Chart 7Canadian Consumers Are##BR##Confidently Spending Surprisingly, the powerful surge in consumer spending has occurred alongside some cooling of the overheated Canadian housing market. The growth rates of existing home sales and prices have both decelerated massively from the pace of the boom years in 2012-16 (Chart 8). The performance of house prices in the three biggest Canadian cities is now a mixed bag, with Vancouver prices reaccelerating, prices in Toronto decelerating and prices in Montreal growing only modestly (middle panel). Regulatory actions to limit the speculative buying of Canadian real estate by foreigners has helped dampen the surge in house prices in some markets. Although the bigger macro-prudential measures designed to tighten mortgage finance rules and reduce the amount of leverage in Canadian housing transactions has likely had a bigger effect. Canadian banks must now conduct stress tests to check if borrowers are able to pay off their mortgages if Canadian interest rates continue to rise. This represents a reduction in the marginal supply of riskier mortgage lending that will help restrain house price inflation in Canada's major cities. In addition, the supply of Canadian homes is growing with new home-building activity, both for single and multiple units, having picked up and overall residential investment growth now up nearly 5% on a year-over-year basis (bottom panel). With signs that the Canadian housing market has stopped rapidly inflating, the BoC can focus its interest rate policy on domestic growth and inflation considerations without worrying about pricking the housing bubble. On that front, the latest edition of the BoC's Business Outlook Survey, released yesterday, provided plenty of reasons to tighten monetary policy further. The overall survey indicator surged back to the peak seen last summer just before the BoC delivered its first rate hike (Chart 9). Capital spending intentions also rebounded back to the 2017 peaks, which bodes well for future gains in investment spending (second panel). Chart 8Canadian Housing Looking##BR##A Bit Less Frothy Chart 9BoC Business Outlook Survey Signaling##BR##Tightening Capacity Constraints The most interesting parts of the Business Outlook Survey were the capacity utilization measures. A greater share of companies were reporting labor shortages (third panel), with the highest percentage of firms reported difficulties in meeting unexpected increases in demand since 2007 (bottom panel). This suggests that the recent surge in employment, wage growth and price inflation are all sustainable. Headline and core CPI inflation are up to 2.1% and 1.8%, respectively, as of November. This is around the midpoint of the BoC's 1-3% target range (Chart 10). The Bank of Canada forecasts that CPI inflation will continue to rise and remain near 2% target in 2018, but all the risks are to the upside. The unemployment rate is now down to 5.7%, the lowest level since 1976 and well below the OECD's estimate of the NAIRU level at 6.5%. Average hourly earnings growth has surged in response, rising to just under 3% on a year-over-year basis since the trough in early 2017. The Phillips Curve appears to be alive and well in Canada. Canadian interest rate markets have already responded aggressively to the stronger growth and inflation data. Our interest rate discounters now show that the money markets are now expecting 61bps of BoC rate hikes over the next six months and 91bps over the next twelve months (Chart 11). With a 25bp hike at next week's BoC meeting now priced with almost full certainty, the current market pricing suggests at least one more hike will happen by June and nearly three more hikes by year-end. That would be even more hikes than we expect from the Fed in 2018, which is important for the Canadian dollar (CAD). The CAD has appreciated 16% since it bottomed out in early 2016, occurring alongside the rise in global oil prices over the same period (second panel). The price of Canada's Western Select grade of crude oil has lagged the move in other oil benchmarks massively over the past several months, due to a lack of pipeline capacity getting oil out of Alberta that has created a supply glut. This may limit the degree to which additional gains in global energy prices benefit the Canadian dollar from a terms-of-trade perspective. This will not prevent the BoC from delivering additional rate hikes, however - especially if that merely matches the 75bps of Fed rate hikes that the FOMC is projecting, and which we expect, over the rest of the year. In terms of investment strategy, the combination of robust Canadian economic growth and rising inflation pressures leads us to continue recommending an underweight stance on Canadian government bonds, as we have maintained since July 11, 2017. This week, we are introducing two new tactical trades that should benefit as Canadian inflation moves higher and the BoC tightens more aggressively in response (Chart 12): Chart 10The Canadian Phillips Curve Is Not Dead Chart 11The Market Now Expects A Lot From The BoC Chart 12Two New Tactical Trades In Canada Short the June 2018 Canada Bankers' Acceptance futures contact vs. the December 2018 contract (middle panel). The market is now discounting the likely maximum amount of tightening that the BoC can deliver by year-end, while there are only little more than two hikes priced by June. Assuming that the BoC hikes next week, that means that there is only one more hike expected by June. With three more BoC meetings scheduled between next week and June, that provides plenty of opportunities for hawkish surprises from the BoC before then. In other words, this trade is a way to play for the BoC being forced to front-load more rate hikes into the first half of 2018 versus the latter half. Long 10yr inflation expectations through linkers versus nominal government bonds, or using CPI swaps (bottom panel). Given the pickup in domestic inflation pressures currently underway, plus the rise in global inflation coming from the surge in commodity prices, there is room for Canadian market-based inflation expectations to rise from the current level of 1.7%. Bottom Line: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will likely hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds. 2017 GFIS Model Bond Portfolio Performance: A Brief Review The turn of the year marked the end of the first full calendar year for the Global Fixed Income Strategy (GFIS) model bond portfolio. This now allows us to report the performance of the portfolio on the same basis as our clients. In the future, we will publish quarterly reviews of the portfolio returns after the end of each quarter in a calendar year (in April, July, October and January). The GFIS model portfolio returned 3.45% in 2017. This underperformed our custom performance benchmark (a blend of the Barclays Global Aggregate Index with global high-yield corporate debt) by -13bps (Chart 13). That underperformance can be entirely attributed to our government bond duration allocations, which lagged the benchmark by -46bps. Our recommended credit positions were a positive contributor, generating 33bps of outperformance primarily through overweights to U.S. Investment Grade and High-Yield corporate bonds. The detailed breakdown of the 2017 returns is presented in Table 1. In terms of the government bond portion of the portfolio, the underperformance can be isolated completely to the longest maturity bucket (10+ years). The combined performance of that bucket for all countries lagged that of the benchmark by -52bps. Given our expectation that global yield curves would bear-steepen in the latter half of 2017, it is no surprise that the bulk of our underperformance came by having too little exposure at the long-end. Also, having too much exposure in Japanese government bonds offering no yield also represented a major drag on the income component of the model portfolio's returns (Chart 14). Chart 13GFIS Model Bond Portfolio##BR##2017 Return Breakdown Table 1GFIS Model Bond Portfolio##BR##2017 Return Breakdown In terms of our credit allocations, favoring U.S. corporate exposure vs. non-U.S. corporates was the right call, generally speaking (Chart 15). However, we did not have enough portfolio weight in that trade to offset the drag on the overall yield from the Japan government bond overweight. Chart 14GFIS Model Portfolio Government Bond Performance Attribution By Country Chart 15GFIS Model Portfolio Spread Product Performance Attribution Looking ahead, the new model bond portfolio allocation for 2018 that we discussed in our final report of 2017 should offer a better chance of outperforming the benchmark.1 Specifically, we dialed down the Japan overweight, increased the U.S. Investment Grade corporate bond overweight, and reduced the curve steepening exposure in Euro Area governments. This not only boosted the overall yield of the portfolio, but also moderated the overall portfolio duration underweight. This portfolio will do well in the first half of 2018 if our base case of an inflation-driven rise in global government bond yields, led primarily by the U.S. where corporate debt is also expected to outperform Treasuries, comes to fruition. Bottom Line: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps underperformance of versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2017. The model's allocation to Australia has proven to be quite volatile as evidenced by the large increase to Australia this month to 7% from 1.7% in last month. As a result, the other commodity country, Canada, is now back to underweight from neutral last month. There are no significant large adjustments in other countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 80 bps in December as the model was underweight the U.K. versus EMU, yet the U.K. was the best performer in the month while EMU underperformed. Since going live in January 2016, the overall model has outperformed the benchmark by 47 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 265 bps. The Level 1 model outperformed the MSCI World benchmark by 19 bps. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 2, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model has turned more bullish on global growth as seen by a 2% increase in aggregate cyclical overweight. However, the model continues to reduce its overweight in the resources-based sectors, and has upgraded financials to overweight on the back of improving momentum. Finally, both utilities and telecom stocks have been moved further into underweight territory. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.
Highlights 2018 Model Bond Portfolio Positioning: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Country Allocations: Divergences in likely central bank policy moves in 2018 will lead to more cross-country bond market investment opportunities. In our model portfolio, we are maintaining underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and adding small overweights in the U.K. and Australia (where rate hikes are unlikely). Spread Product: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Feature Two weeks ago, we published our "Key Views" report, outlining the main fixed income investment implications deriving from the 2018 BCA Outlook.1 In this, our final report of 2017, we translate those Key Views into direct allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. As we always remind our clients, our model portfolio is intended as a vehicle to communicate our opinions on the relative attractiveness and trade-offs between fixed income countries and sectors. That is to say, the portfolio not only includes our traditional individual country and sector recommendations, but attaches actual weightings to those views within a fully invested hypothetical bond portfolio. The main takeaway from our Key Views is that bond market performance, and ideal asset allocation, is likely to look very different as the year progresses (Table 1). The first half of the year will see continued strong global growth and slowly rising inflation, but with central banks only slowing shifting to a less accommodative policy stance. This will create an environment where global bond yields will rise but with credit markets outperforming government bonds. The story will play out differently in the latter half, however, as worries over global growth expectations for 2018 will create more market volatility - albeit with lower cross-asset correlations as central banks act in a less-coordinated fashion than in recent years. Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Top-Down Bond Portfolio Implications Of Our Key Views The main predictions for 2018 in our Key Views report from December 5th were the following: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. The first step in translating these themes into allocations into our model bond portfolio is to determining the ideal top-down asset allocation parameters for the start of the 2018: Maintain a moderate overall level of portfolio risk. Both bond yields (Chart 1) and credit spreads (Chart 2) are at the low end of their historical ranges since 2000. This suggests that bond market returns will be much lower than in recent years, simply because initial valuations are not cheap. Coming at a time when bond volatility is also at historically depressed levels, and with central banks starting to slowly take away the monetary punch bowl, keeping overall portfolio risk at modest levels is prudent. Within the GFIS model bond portfolio, that means keeping our tracking error versus our custom benchmark performance index well below our maximum target level of 100bps (Chart 3). Chart 1Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 Chart 2Historical Range Of Global Credit Spreads, 2000-2017 Maintain a below-benchmark overall portfolio duration. The combination of solid global growth, rising inflation and a slower pace of bond buying by the major central banks all suggest that bond yields will move higher in 2018. We will continue to target a recommended portfolio duration that is one year short versus our benchmark index (Chart 4). Chart 3Maintain Moderate Overall Portfolio Risk Chart 4Stay Cautious On Duration Risk Maintain an overweight stance on corporate credit over government bonds, focusing on the U.S. Although spreads are tight in so many asset classes, the global growth and monetary backdrop remains supportive for the outperformance of credit over government bonds. We recommended focusing on U.S. corporate credit, both Investment Grade (IG) and High-Yield (HY), where growth momentum remains solid and Fed policy is not yet restrictive. After setting those broad portfolio parameters, our recommendations get more interesting in terms of country allocations. Bond yields within the developed markets have become highly correlated to inflation expectations in the past few years (Chart 5). This is no surprise given how strongly central banks have tied their monetary policy decisions to their own inflation forecasts, and to market-based and survey-based inflation expectations. Inflation is likely to move higher next year alongside tight global labor markets and higher oil prices. If the bullish views on oil from BCA's commodity strategists comes to fruition, this implies that both market-based inflation expectations can rise and yield curves can bear-steepen. The key to the latter will be how fast central banks respond to faster rates of inflation. Yield curve steepness remains highly correlated to the level of REAL interest rates. Curves steepen when real interest rates decline and vice versa. Lower real rates can happen in two ways - bullishly, if central banks cut policy rates faster than inflation is falling; or bearishly, if central banks do not hike rates as fast as inflation is rising. We see the latter as being the likely story in 2018, which will lead to steeper government bond yield curves but through higher yields and rising inflation expectations. In Chart 6, where we plot the level of real central bank policy rates (deflated by 10-year CPI swaps as a measure of inflation expectations) vs. the 2-year/10-year bond yield curves. If global inflation expectations merely follow the path implied by our bullish oil forecast (Brent crude average $65/bbl in 2018), and central banks did not respond with rate hikes, then this would generate lower real interest rates (the "x" in each panel of the chart) and steepening pressure on yield curves. Chart 5Bond Yields In 2018 Will Be Driven More##BR##By Inflation Expectations Chart 6Steepening Pressure On Yield Curves##BR##From Inflation In 2018 We don't see all central banks responding the same way to an oil-driven move higher in inflation. Lower unemployment rates, and other measures of diminished economic slack, will be needed to give policymakers confidence that their economies can tolerate higher interest rates. Judging central banks along these lines will create more interesting country bond allocation decisions in 2018 (Chart 7). Specifically, we see a greater likelihood that the Fed and Bank of Canada (BoC) can actually raise interest rates next year. It will be much harder for the Bank of England (BoE) to raise rates given sluggish domestic economic growth, lingering Brexit uncertainty and the fact that market-based inflation expectations have already peaked. The Reserve Bank of Australia (RBA) will also be unable to hike rates next year given the lack of core inflation pressures and with an unemployment rate that is still much higher than previous cyclical troughs. This leads us to add moderate portfolio overweights in the U.K. and Australia to the government bond portion of our model bond portfolio, while maintaining our current underweight stances for the U.S. and Canada (Chart 8). The ECB and Bank of Japan (BoJ) will be nowhere near a point where interest rate hikes would be considered, although the decisions those banks make with their asset purchase programs will be a bigger issue for their bond markets in 2018. Chart 7Tight Labor Markets Will##BR##Influence Bond Returns Chart 8Monetary Policy Divergences##BR##Will Drive Country Allocation Bottom Line: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. The Asset Allocation Implications Of Slower Central Bank Asset Purchases The big risk factor for global bonds in 2018 will be how markets respond to less buying from the Fed, ECB and BoJ. As the growth rate of the expansion of the major balance sheets slows, bond yields have the potential to rise through two channels: higher term premia on longer maturity bonds and the market pulling forward the expected future path of interest rates. This will become a major issue for Euro Area bond markets in the 2nd half of 2018, as the ECB will be forced by strong domestic growth and rising inflation pressures to announce a full taper of its asset purchase program by the end of 2018. This will come on top of a slower pace of buying by the BoJ (who is now targeting a price target on bond yields rather than a quantity target), and the Fed allowing some run off of its massive balance sheet. The result is that the growth rate of the major developed market central bank balance sheets is likely to slow to a low single-digit pace in 2018 (Chart 9), creating upside potential for global yields. The case for significant underweights in Euro Area fixed income will be much stronger later next year when the ECB will be forced to prepare the market for a taper. But in the first half of 2018, the impact of the ECB's purchases will continue to dampen Euro Area bond yields. At the same time, Japanese yields will remain pegged near 0% by BoJ buying. In terms of our model bond portfolio, we are maintaining an overweight stance on low-beta Japan given our views on rising global bond yields, while keeping aggregate Euro Area bond weightings close to neutral (and looking to go more aggressively underweight later in the year as the ECB taper talk ramps up). Bond markets that are less propped up by ultra-accommodative central banks will create a more volatile market backdrop for global fixed income as the year progresses. That is hardly a provocative statement, of course, given the starting point of utterly low realized bond market volatility (Chart 10). As discussed earlier, our views for 2018 lead us to recommend a more moderate portfolio risk level in 2018. The potential for higher central-bank driven market volatility fits with that expectation. Chart 9Global Yields Will Rise As##BR##Central Banks Buy Fewer Bonds Chart 10The Low Bond Vol Regime##BR##Looks Stretched A slower pace of central bank bond buying also has another implication for portfolio construction. With the wave of central bank liquidity becoming a less dominant factor, cross-asset correlations should diminish. We can see that by looking at the average correlation between sectors within our model bond portfolio benchmark index (Chart 11). We have found that the correlation is itself highly correlated to the breadth of global economic growth, as measured by our leading economic indicator diffusion index (top panel). But the average correlation is also linked to the growth rate of central bank balance sheets (bottom panel), which is a by-product of massive asset purchases reducing global macroeconomic risks and forcing investors to plow into similar asset classes to chase acceptable returns. Slightly less coordinated global growth, and less active central banks, should result in lower market correlations in 2018. At the same time, as central banks shift to a less accommodative stance - especially in the U.S. - the uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart 12). This will likely lead us to cut our recommended overweight allocations to U.S. IG and HY corporate debt in our model portfolio later in 2018. To begin the year, however, we are keeping an overweight stance until the Fed is forced to signal a shift to a more hawkish stance because of rising U.S. inflation. Chart 11Expect Lower Global Bond##BR##Correlations In 2018 Chart 12The Link Between U.S. Growth,##BR##Bond Vol & Credit Spreads Bottom Line: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Summing It All Up Chart 13Aiming For Moderate Carry##BR##In Our Model Portfolio On Page 12, we show our model bond portfolio allocations after making some changes to reflect our key views for 2018. We are doing some tweaks to our existing recommendations: modestly increasing our overweight U.S. IG corporates allocation at the expense of U.S. Treasuries; reducing our underweight in the Euro Area by reducing the large Italy underweight; adding exposure to the U.K. and Australia; while cutting our large overweight in Japan. The latter was there as a desire to get more defensive on the portfolio's duration stance, but having such a large allocation has left our portfolio with no yield advantage versus the custom benchmark index (Chart 13). With the changes we are making this week, the model bond portfolio will have a yield that is 12bps over that of our custom index. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Table 4Capex In The Year After A Corporate Tax Cut Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Table 6...And In The 12 Months After Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. 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 Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations
GAA DM Equity Country Allocation Model Update One thing worth noting is that the model now is neutral on Canada, after a long-standing underweight. Canada's valuation ranking had been improving, but the signal was only confirmed this month by the technical ranking. There are no significant changes among other countries, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 68 bps in November as the model was underweight both the U.S. and Japan, which were the only two countries to outperform the MSCI World benchmark in November! The underweight in the U.K. and Australia worked well, but not enough to offset the loss from the overweight of the euro area. Since going live in January 2016, the overall model has outperformed the benchmark by 157 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 489 bps. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model has turned more bullish on global growth and consequently increased the aggregate cyclical overweight. However, within the cyclical basket there has be re-shuffle from resources-based sectors to consumer discretionary and technology stocks. This was driven by improving momentum in these two sectors. Finally, utilities stocks have been downgraded to underweight on the back of the bullish growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Highlights The centrist consensus is breaking down across the developed world; In its place is rising political plurality, with non-centrist and anti-establishment parties gathering support; This trend is not to be feared by the markets; Political systems that encourage political plurality - such as those of continental Europe - are more stable in the long run than those promoting political duopoly; Establishment parties in Europe can neuter single-issue parties by selectively adopting their agenda; Emergence of a third party in the U.S. would be positive for both the markets and the economy in the long run. Feature Chart 1European Border Enforcement Is Effective Germany's Social Democratic Party (SPD) signaled on November 23 a willingness to entertain another Grand Coalition with its rival the Christian Democratic Union (CDU). If coalition talks reproduce the centrist coalition that has ruled Germany since 2013, the risk of a new election will be averted. While European markets breathe a sigh of relief, there is much to be concerned about. First, the left-leaning, liberal Socialists will likely force Chancellor Angela Merkel to accept that family reunification for asylum claimants will remain an eligible migration route into the country. This means that the 1.3 million asylum seekers that have entered Germany since 2015 will be able to apply for family members to join them, swelling the numbers of migrants from Africa and the Middle East. This could raise tensions inside Germany and increase support for anti-establishment parties. This risk is overstated, as asylum seekers to Germany have collapsed since the EU stepped up enforcement of its borders after the 2015 crisis (Chart 1). Nonetheless, the perception that Merkel is soft on migrants will hound her for the remainder of what we believe will be her last term in power. Second, the SPD performed terribly in the September election, garnering only 20.5% of the popular vote, its worst performance since March 1933 (Chart 2).1 If the German Socialists enter another Grand Coalition, it will leave the anti-establishment, anti-immigrant, and anti-EU Alternative für Deutschland (AfD) in the ceremonial role of the leader of the opposition.2 Chart 2The Center-Left Has Collapsed In Germany This brings up the larger concern for investors: collapse of the centrist monopoly on political power in the West writ large. Germany is hardly the only country that is facing centrifugal forces that are eroding the hold on power by the center-left and center-right establishment parties. Across a number of critical economies, the center-left and center-right political behemoths are giving way to new entrants into the political system. This political plurality means that post-World War Two era centrist duopolies are breaking down as new parties, many of them anti-establishment and populist, enter the scene. Should investors fear this development? The consensus says yes. We disagree. Even in the United States, we doubt that a "third party" would be a negative development. Introducing The Political Concentration Index Chart 3 shows the developed economy measure of our BCA Political Concentration Index (PCI), which we constructed using the Herfindahl-Hirschman index normally used to measure the level of monopoly in a particular industry.3 Our modified index measures political - rather than economic - monopoly. We replace "firms" with "parties" and "industry" with "political system" (i.e., country). A country with a single ruling party would register a 1 on the index, while a country with 10, equal-sized parties in its parliament would register a 0.1. Chart 3Political Plurality Is On The Rise In The Developed World As Chart 3 illustrates, the developed economy concentration of political power has declined considerably. Power is concentrated in the hands of more and more political parties. Chart 4 shows the PCI of ten major western economies, illustrating that the culprits for the overall collapse of political monopoly are Australia, Canada, Germany, Spain, Sweden, and the Netherlands. Our indicator would illustrate an even greater decline of political concentration if we excluded the U.S. and the U.K. Somewhat surprisingly, Italy is actually holding up well, with current levels of political concentration in line with the post-World War Two era and higher than the free-wheeling 1990s. Chart 4Political Concentration Is On The Decline Across The Developed World France also surprisingly illustrates rising political concentration, at least relative to the 1980-1990s. However, this result also reveals the weakness of our index. Our measure is ignorant of the rise and fall of major parties. As such, it has failed to take into account the massive political earthquake that has occurred in France, where President Emmanuel Macron's La République En Marche! (REM) has completely replaced the Socialist Party as the main center-left French party. This shift is not picked up by the index as the degree of concentration of political power in the French National Assembly remains unaltered. Overall, the data confirm the suspicions of many of our clients that the political consensus is breaking down across the western world. There are likely three culprits: The economic dimension is eroding in relevance: The post-World War Two organization of western political parties across the left-right economic spectrum echoed the late-nineteenth and early-twentieth century cleavages between the conservative bourgeoisie and revolutionary proletariat. The Industrial Revolution created immense wealth across Europe and North America, but also immense inequalities. As the urban proletariat grew in size, it demanded political and economic rights. For example, the German SPD remained committed to a radical proletariat revolution almost right up until the First World War. While the question of economic redistribution remains relevant today, the left-right economic axis is not as cogent in a world where living standards have risen massively since the turn of the last century. Culture wars: With the vast majority of western voters no longer responding to basic, Malthusian needs, identity issues are rising in prominence and drawing votes away from the centrist parties arrayed along the left-right economic spectrum. Several single-issue parties have found a permanent foothold in the political system, from the German Greens (since 1980) to the U.K. Independence Party (since 1993). A number of young and old parties have found particular success focusing on immigration, most prominently the Dutch Party for Freedom (founded in 2006), the Swedish Democrats (founded in 1988), the AfD (founded in 2013), and the New Zealand First party (founded in 1993). Generational cleavages: Voters born after the Cold War are particularly drawn to new and anti-establishment parties. Spain's Podemos and Italy's Five Star Movement (M5S) have had particular success appealing to young voters. Similarly, parties with a strong anti-immigration and anti-globalization focus have found success recruiting older voters. There is no single unifying theory that explains the erosion of the left-right economic spectrum as the defining political cleavage in the West. For example, France's Front National - anti-establishment, Euroskeptic, and anti-immigration - is particularly successful in recruiting young French voters, whereas its populist peers generally have not. Each country has its own set of idiosyncratic variables that explain how the political system is evolving. These range from endogenous factors (political system, demographics, ethnic makeup) to exogenous factors (economic crisis, membership in the EU, geopolitical risk, etc.). Even in the case of the U.S. - which shows no decline in political concentration (Chart 4), as Republicans and Democrats so far maintain a grip on their duopoly - numerous cleavages are evolving. Primary elections, particularly in the Republican Party, are pitting anti-establishment candidates - often ideologically aligned with the small government "Tea Party" - against establishment centrists. While these anti-establishment policymakers are officially aligned with the GOP, they often operate as an independent bloc in the House of Representatives. Bottom Line: For a number of reasons, different in each political system, the left-right economic spectrum is no longer driving voter preferences. Hence it should no longer serve as a starting point of analysis. Politicians who realize this - such as President Donald Trump or President Emmanuel Macron, both of whom challenged left-right orthodoxies on economic policy - are rewarded with surprising upsets. Our Political Concentration Index suggests that a trend is underway. Should investors fear the trend? The short answer is no. Political Plurality Is Stabilizing Political plurality should not be feared. True, in the short term, political plurality will produce political volatility. Aside from the ongoing German coalition talks, investors may remember the recent Spanish and Greek elections. Both countries had to hold two elections before producing a relatively stable political equilibrium due to the breakdown in what were traditionally two-party systems.4 Our PCI obviously suggests that similar outcomes are likely and to be expected. Germany could still become a case in point and Italy looms ominously in Q1 2018. However, there are three reasons why risks of more political plurality are overstated. The first is obvious. Chart 5 is the same as our Chart 3, but we have grafted onto it average GDP growth and unemployment rates. There is no clear difference in economic performance between periods of rising and falling political concentration. Chart 5The Economy Does Not Drive Political Concentration The second is also obvious from Chart 5. There appears to be a pattern in the rise and fall of political concentration. In other words, investors should not necessarily extrapolate today's low concentration into the future. We suspect that the reason for the natural oscillation in our index is also the third reason that more political plurality is not a risk to the markets and the economy. A field of multiple parties allows establishment, centrist politicians to steal certain popular aspects of the electoral platform of the anti-establishment parties. Over time - what appears to be a roughly 7-year interval, or two electoral cycles on our chart - the establishment simply swallows the most competitive portions of the anti-establishment platform, repackages it in a way that is palatable for the median voter, and rebrands it as an establishment policy. The recent Austrian election is a perfect case study. Austria held a general election this year in October and the anti-establishment Freedom Party (FPÖ) came in third with 26% of the vote, a 5.5% increase from its 2013 outcome. It was not, however, the best performance for the FPÖ, as it had several strong performances in the late 1990s (Chart 6). Furthermore, investors often make the mistake of only comparing the performance of a party to the last election. In case of Austria, that means that analysts are ignoring four years' worth of polling data. In the particular case of the FPÖ, that means ignoring that the party's 26% performance was an absolute crushing collapse. As Chart 7 shows, the FPÖ went from leading in the polls for much of 2016, at one point reaching 35% support, to coming in third. Why? Chart 6Austrian Populists Have Been Here Before Chart 7The Establishment Stole FPO's Thunder As we illustrate in Chart 7, the Austrian establishment was not stupid. The center-right People’s Party (ÖVP) appointed 31-year-old Sebastian Kurz as its leader in May 2017. Kurz promptly shifted the ÖVP towards the FPÖ’s policy on immigration while retaining centrist views on literally everything else. From that point until the election, the centrist ÖVP crushed the FPÖ in the polls (the ultimate vote swing was nearly 15%). What the Austrian example shows is that a plural political system allows establishment, centrist parties to co-opt portions of the anti-establishment agenda without bringing them on board. In the long term, single-issue parties that focus on anti-globalization, immigration, the environment, or low-income families could see their support erode as the establishment parties adopt portions of their electoral manifesto, without setting-off major political earthquakes. Our forecast is that anti-immigration, populist parties in Europe have likely seen their peak in 2017. Other center-right parties will observe Kurz's success.5 There is simply no reason for them to stand in favor of open borders for asylum seekers in Europe going forward, particularly since newly arrived immigrants cannot vote. As such, it is far more likely that Kurz becomes a model for conservatives rather than, say, Angela Merkel. We concede that Merkel may be the last conservative holdover on immigration. She appears to be stuck defending her decision made in 2015 and is unable to pivot away from that episode. Our strong conviction view is that her successor as head of the CDU will have no such qualms and that the next conservative Chancellor of Germany will close all non-European immigration avenues to the country. Bottom Line: BCA's Political Concentration Index illustrates that political pluralism abates every seven years, or two electoral cycles. This is because single-issue and anti-establishment parties introduce new ideas and policies into the political marketplace, allowing the establishment players to co-opt some of those ideas and win elections without causing a dramatic - and market shattering - break with the past. Beware Of Political Duopolies Is there nothing that investors should fear in our data? No, they should fear persistent political monopolies and duopolies. Take the U.S. and the U.K. It is interesting that the two countries that have experienced the most populist political outcomes in the past two years - Brexit, Trump - are also consistently rated as having the highest political concentration (see Chart 4 on page 4). Why? We suspect that it is because the establishment parties in both political systems try to be catch-all, "big tent" conglomerates that capture a wide array of ideological views on several issues.6 By trying to capture diverse positions, including some fringe ones, they are in danger of becoming entrapped by them. One of the reasons for the "big tent" nature of Anglo-Saxon parties is the "first-past-the-post" electoral system of individual electoral districts. Unlike proportional representation systems favored on the European continent, first-past-the-post electoral systems radically reduce the incentives for small parties to launch independent campaigns.7 For example, UKIP captured 12.7% of the vote in the 2015 election, but it was awarded only one seat in the House of Commons. Such a record of failure is difficult to maintain for any political entity over a long period of time. Eventually, small parties are swallowed whole by their big tent counterparts. The problem with swallowing the whole party, instead of merely biting off an anti-establishment issue here and there, is that the big tent parties often swallow more than they can chew. In the case of the U.K.'s Conservative Party (which has almost wholly swallowed the anti-establishment UKIP), it has been forced to push forward with Brexit, which is dragging on the economy and making it difficult to govern. In the case of the Republican Party in the U.S., the Republicans absorbed the anti-establishment Tea Party, but the two wings of the party are at risk of descending into open warfare. The particular danger for U.S. parties is that their primary elections are normally poorly attended, particularly in midterm election years that lack the star-power of presidential candidates. This means that a candidate representing the far-left or far-right fringe can often win a candidacy with merely 4%-7% of the electorate in each district (the average turnout for primary elections in a midterm year).8 They then can easily proceed to be elected to the House of Representatives due to the fact that so few American electoral districts are truly competitive (Chart 8). As these anti-establishment voices gather force in Congress - 41 members of the GOP belong to the Tea Party-aligned Freedom Caucus for example - they can heighten already considerable polarization by preventing compromise (Chart 9). Chart 8No Competitive Districts Left In The U.S. Chart 9Polarization In The U.S. Is Historically High A heightened state of political polarization, which persists throughout the term in office, is far more market-relevant than heightened volatility around an election produced by more political plurality. For the most part, Europe's political systems have weathered a severe double-dip recession (triple-dip in Italy's case!), a massive loss of political confidence in European institutions, and a Biblical migration crisis with relatively few early elections (Table 1). In this turbulent period, many European governments have pushed through draconian austerity measures, far-reaching economic structural reforms, and agreed to fund or receive costly bailout programs. When anti-establishment parties came to power - as they legitimately did in Greece - they quickly migrated to the middle in order to govern, needing the votes of other parties. Table 1Europe: Less Volatile Relative To Context Empirically speaking, there is no evidence that low political concentration is therefore inferior to the perceived stability of high political concentration exhibited in the U.S. and the U.K. The American and British economies both have seen generally better economic performances since 2008, yet they are struggling with dramatic bouts of populism in 2016.9 In the U.K.'s case, Brexit will reduce potential GDP. In the U.S.'s case, Trump's tax cuts will be inflationary, could hasten the next recession, and will likely exacerbate income inequality. We do not have a view on whether a third party will emerge in the U.S. Political polarization is a powerful trend at present, and since by definition it promotes the existence of two opposing ideological camps, it reinforces the two-party system. Republicans want to maintain control of the conservative base and hence cannot afford to let the Tea Party split off, while Democrats want to control the liberal base and cannot afford to let the progressive wing split off. If either party fractures, the other benefits. Nevertheless, there is nothing unique about the U.S. electoral system that would prevent a breakdown of the American political duopoly: other first-past-the-post systems exhibit political plurality, most notably in Canada. If a third party does emerge, we would wager that it would increase, not decrease, political stability; and reduce, not increase, political polarization. For example, if Tea Party policymakers were to run as independent candidates, it would free up both Tea Partiers and centrist Republicans to pursue their preferred policies in Congress. Centrist Republicans could vote with the Tea Party on matters of common concern and vote with the Democrats on issues where the Tea Party is deemed to be on the fringe. The basic ability to pass a budget would not be hindered by the Tea Party's single-mindedness on government spending, yet voters demanding tighter budgets would not be denied representation. Alternatively, if a new single-issue party emerged, say one favoring tighter immigration policy, Republicans would be free to co-opt aspects of its view on immigration and neutralize the threat of losing votes. They would not be forced to absorb the entire party and pursue hardline policies that would cause gridlock with Democrats. Bottom Line: Empirical evidence since the 2008 Great Financial Crisis does not support the conventional wisdom that low political concentration (i.e., political plurality) is less favorable for investors than high political concentration. Both the U.S. and the U.K., which score the highest on our PCI, have produced highly volatile political outcomes. Investment Implications Investors should not worry about the emergence of new parties in Europe. Particularly harmless are single-issue parties, specifically those focusing on tighter immigration controls. Conservative parties across Europe have already adopted more stringent immigration policies while still sounding sane, a potent electoral mix relative to some of the populist anti-immigrant parties currently vying for the votes of concerned citizens on the continent. Meanwhile, we do not fear the emergence of a third, or fourth, party in the U.S. In fact, such a development could play a role in reducing historically high political polarization in the country. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Yes. That 1933 election. 2 There is no official "leader of the opposition" in Germany and as such the AfD leadership is merely ceremonial. The left-wing Die Linke was in the same position from 2013-2017 with little effect. In fact, Die Linke saw only an incremental increase in its support (0.6%) between the two elections. 3 Regular readers of Geopolitical Strategy will know that we are big fans of the Herfindahl-Hirschman index. We have applied it before to measure geopolitical hegemony. Originally, the index was designed to assist in competition law and antitrust cases as it is an indicator of the amount of competition between firms in a particular sector. The formula for the index is shown below, where si is the market share of firm i in the market, and the N is the number of firms; 4 Spain held an election in December 2015 and another in June 2016. The latter produced a minority government led by the center-right People's Party that is essentially supported by the Spanish Socialists Workers' Party (PSOE). Greece similarly held two elections, one in January 2015 and another in September of that year. 5 The German, establishment, Free Democratic Party (FDP) did so in the most recent election, copying ÖVP's focus on tight immigration policy. It has seen its support rise to 10.7%, a substantive increase from 2013. 6 We admit that the case for the U.K. as a political duopoly is harder to make given that there are third (and fourth) parties; although both the Labour Party and the Conservative Party have cleavages on the economy, globalization, and European integration that few European peers have. This is largely due to both parties' attempt to capture a diverse coalition of views. 7 First-past-the-post refers to an electoral system where the country is divided into electoral districts. In each electoral district, the party that wins the most votes generally sends its candidate to the legislature. While there are some variations on this model, and some mixed systems, this electoral system tends to favor political duopolies. In political science, this tendency has often been referred to as Duverger's law (named after the French sociologist Maurice Duverger who first observed this phenomenon). 8 Please see Elaine C. Kamarck, "Increasing Turnout In Congressional Primaries," Center for Effective Public Management at Brookings, dated July 2014, available at brookings.edu. 9 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.