BCA Indicators/Model
Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite and long-standing indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter monetary policy is required, validating the recent hawkish shift by policymakers. Feature September has been an active month for central bankers. The Bank of Canada hiked rates again, the European Central Bank gave strong hints that a tapering of its asset purchase program will soon be announced, and the Bank of England warned that tighter policy might soon be required. Just last week, the Federal Reserve began the process of reducing its massive balance sheet while also making no changes to its plans to hike interest rates several times over the next year. This is setting up a potential nasty surprise for bond markets. Investors have became deeply skeptical about the possibility of policymakers shifting in a more hawkish direction without an obvious trigger from faster inflation. Yet the global economy is in a synchronized expansion with the largest share of countries operating at (or beyond) full employment since the pre-crisis years. Inflation is in the process of stabilizing, or grinding higher, in most of the major economies. In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter policy is required, validating the recent hawkish shift by policymakers (Chart of the Week). Chart of the WeekGrowing Pressures To Tighten, According To Our Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Upward Pressure On Global Bond Yields The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are all near or above the zero line, providing context for why central bankers have shifted towards a more hawkish bias of late. Actual rate hikes are still not likely over the next few months outside of the Fed and BoC (we remain skeptical on the potential for the BoE to realistically tighten policy). More importantly, the underlying growth and inflation pressures indicated by the Monitors suggest that policymakers will maintain a hawkish bias (or, at best, a neutral tone) in their communications with the markets. One new addition to the individual country sections in this Chartbook are charts showing the Monitors, broken into growth and inflation components. The conclusion from these new charts is that the current level of the overall Monitors is a reflection of strong economic growth in all countries, with the inflation components giving more mixed signals. The Fed Monitor: Neutral For Now, Likely To Head Higher Again Our Fed Monitor has drifted lower over the past several months, and now sits just slightly above the zero line, calling for no imminent need to change U.S. monetary policy (Chart 3A). FOMC members have been sending more balanced messages in their recent speeches, specifically noting the confusing mix of what appears to be a U.S. economy operating at full employment but with slowing core inflation (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. When looking at the breakdown of our Monitor into its main inputs (Chart 3C), the growth component remains in a steady grinding uptrend. The inflation component had softened since the peak earlier this year, but the latest reading shows a slight uptick. Chart 3CPressure On The Fed From U.S. Growth. Is Inflation Next? Looking ahead, we expect realized U.S. inflation, which looks to be stabilizing after the downturn since the spring, to grind higher alongside a steadily expanding U.S. economy. With corporate profits and household incomes expanding, and with leading indicators steadily climbing, there is little reason to expect much sustained slowing of U.S. growth in the next few quarters. The next move in our Fed Monitor will likely be upward. The historical correlations between changes in our Fed Monitor and changes in U.S. Treasury yields suggest that any renewed increase in the Monitor should put more upward pressure on the front end of the yield curve than the back end (Chart 3D). This suggests that Treasury curve would bear-flatten as the market priced in more Fed rate hikes. However, we see a greater near-term risk of a bear-steepening of the curve given the low level of market-based inflation expectations. The Fed will want to see those rise - which will require signs of realized inflation rebounding - before delivering another rate hike, perhaps as soon as December. Chart 3DThe Fed Monitor Is Most Correlated To Shorter-Maturity USTs BoE Monitor: The Window Is Closing For A Rate Hike Our Bank of England (BoE) Monitor has been in the "tight money required" zone since the end of 2015 and has not signaled a need for easier monetary policy since 2012 (Chart 4A). This is unsurprising with the U.K. economy running beyond full employment for over three years alongside a steady rise in inflation (Chart 4B). Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. The after-effects of the Brexit vote last year are still an issue for the U.K. economy and the BoE. The central bank eased monetary policy (rate cuts and QE) after the Brexit shock as insurance against the massive economic uncertainty. Yet that not only provided stimulus to an economy that was already operating beyond full employment, but also resulted in a 16% peak-to-trough decline in the British Pound. The result: a surge in headline U.K. inflation to 2.9%, well above the BoE's 2% target. The BoE sent a hawkish message at the policy meeting earlier this month, signaling that interest rates would have to rise if growth evolves in line with their forecasts. We are skeptical on that front: U.K. leading economic indicators have rolled over, real income growth has stagnated due the high inflation, and business confidence continues to be dragged down by Brexit uncertainties. Also, the greater stability in the trade-weighted Pound - now essentially flat versus year-ago levels - should result in some cooling off of the currency-driven surge in inflation, which the inflation component of our BoE Monitor is already signaling (Chart 4C). Chart 4CThe Inflation Component Of The BoE Monitor Has Collapsed We remain neutral on Gilts, as we expect the BoE to remain on hold and not follow through on their recent hawkish commentary (Chart 4D). Chart 4DThe Gilt/BoE Monitor Correlations Are Higher At The Long-End ECB Monitor: On Course For A 2018 Taper Our European Central Bank (ECB) Monitor has steadily climbed over the course of 2017 and now sits right on the zero line (Chart 5A). The solid and broad-based economic expansion in the Euro Area has soaked up spare capacity. The unemployment rate has fallen to an 8-year low of 9.1%, suggesting that the Euro Area economy is very close to full employment for the first time since the Great Recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity In Europe Dwindling Fast Against that strong growth backdrop, core inflation has been grinding higher off the lows, but at 1.4% remains below the ECB 2% target for headline inflation. When looking at the components of our ECB Monitor, however, rising inflation pressures have been as important a reason behind the pickup in the Monitor as stronger growth (Chart 5C). Chart 5CGrowth Has Pushed The ECB Monitor Higher This Year The deflation threat that prompted the ECB to begin its own asset purchase program in 2015 has passed, and we expect the ECB to announce a tapering of the bond buying starting in January 2018. If growth and inflation evolve according to the ECB's forecasts - which is likely barring an additional major surge in the euro from current elevated levels - then there is a good chance that the asset purchase program will be wound down by the end of 2018. Interest rate hikes are still some time away, though. The market is currently discounting a first 25bp ECB rate hike around October 2019. We agree with that pricing, as the ECB will "follow the Fed playbook" and not begin rate hikes until well after the end of the asset purchase program. We remain underweight Euro Area government debt, with a bias towards bear-steepening of yield curves as inflation expectations should steadily climb higher and the ECB keeps policy rates unchanged (Chart 5D). Chart 5DStronger Bond/ECB Monitor Correlations At The Short-End BoJ Monitor: Creeping Higher, Surprisingly The Bank of Japan (BoJ) Monitor has steadily climbed throughout 2017 and now sits right on the zero line (Chart 6A). While overall inflation rates remain well below the 2% BoJ target, the steady economic expansion has absorbed spare economic capacity, with the unemployment rate now down to a mere 2.8% (Chart 6B). Both the growth and inflation components of our BoJ Monitor have been rising (Chart 6C). Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation While the pickup in inflation off the lows is a welcome sight for the BoJ, there is no immediate pressure to shift to a less accommodative policy stance (Chart 6D). In fact, the central bank has already done its own version of a "taper" by moving to a 0% yield target on JGBs one year ago. Maintaining that yield level has required a slower pace of asset purchases by the central bank, which are running at an annualized pace of 70 trillion yen so far in 2017, below the 80 trillion yen target for the current QE program. Chart 6CTight Labor Market, But Still No Inflation We do not see the BoJ abandoning the 0% yield target anytime soon. By depressing JGB yields, the BoJ hopes to engineer additional weakness in the yen which will feed through into faster inflation and rising inflation expectations. This appears to be the only way to generate any inflation in Japan, even with such a low unemployment rate. Chart 6DLow Correlations Between the BoJ Monitor & JGB Yields It will require a rise in Japanese core inflation back towards 2% before the BoJ will even begin to discuss any real tapering of its QE program. Thus, JGBs will remain a low-beta "safe-haven" among Developed Market government bonds, where there is greater risk of central bank tightening actions that will push yields higher. Remain overweight. BoC Monitor: More Tightening To Come The Bank of Canada (BoC) Monitor has been comfortably above the zero line throughout 2017 (Chart 7A). The Canadian economy has shown robust growth, which has soaked up spare capacity (Chart 7B). The BoC is projecting that the output gap in Canada will likely be fully closed before the end of this year. The surprising surge in growth is likely to continue given the strength in the leading economic indicators and the robust readings from the BoC's own Business Outlook Survey. Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada The central bank has already responded to the faster-than-expected pace of growth with two 25bps rate hikes since July. This took place even without much of a pick-up in realized inflation or in the inflation component of our BoC Monitor (Chart 7C). Clearly, the BoC is focusing more on the rapidly accelerating economy, with real GDP growth surging to a 3.7% year-over-year pace in Q2. With the BoC Overnight Rate still at a very low level of 1%, well below the central bank's own estimate of the neutral "terminal" rate of 3%, there is room for additional rate hikes as long as growth remains robust. Chart 7CRising Growth Pressures On The BoC, Still No Inflation The surging Canadian dollar is not yet a concern for the BoC, as this reflects both the improving Canadian economy and the Fed taking a pause on its own rate hiking cycle. With the latter poised to resume in December and continue into 2018, the appreciation of the "Loonie" is likely to cool off, even if the BoC keeps raising rates. We have maintained an underweight stance on Canadian bonds, with a curve flattening bias, since mid-year (Chart 7D). We are sticking with that stance, even with the market now priced for nearly 70bps of additional rate hikes over the next year. If the Canadian economy continues to grow rapidly, and the Fed returns to hiking rates, the BoC can tighten to levels beyond current market pricing. Chart 7DA Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve RBA Monitor: Conflicting Forces Our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory (Chart 8A). Core inflation has picked up slightly, dragging market expectations along with it, but headline price growth has declined below 2% (Chart 8B). However, commodity prices continue to ease, survey-based measures of inflation expectations have pulled back and the inflation component of the RBA Monitor has retreated from the highs (Chart 8C). Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA The RBA is facing conflicting forces of an improving labor market and booming house prices, combined with high consumer indebtedness and nonexistent real wage growth. Though employment growth has recently spiked, part time employment as a percentage of total is just starting to roll over and underemployment remains elevated. Labor market conditions will need to tighten considerably for wages to rise and consumer confidence to recover. A wide output gap, mixed employment backdrop and a lack of inflation pressure will likely keep the policymakers on hold for longer than the market expects. Chart 8CRBA Facing Surging Growth Pressures & Cooling Inflation Pressures We are currently at a neutral stance on Australian government bonds, given the mixed economic backdrop. Instead, we prefer to maintain our 2yr/10yr yield curve flattener trade. The short end will remain anchored by an inactive RBA, with the long end facing downward pressure from soft inflation expectations and macro-prudential measures in the housing market dampening credit growth. Even if the RBA were to tighten policy as markets expect, the yield curve would flatten. Additionally, negative correlations between Australian yield curves and the RBA monitor have been more robust in the post-crisis era (Chart 8D). As labor markets continue to improve, the other components of the Monitor, such as wages, retail sales and consumer confidence, will follow. Chart 8DThe Entire Australian Curve Is Highly Correlated To Our RBA Monitor RBNZ Monitor: Rate Hikes Are Needed Our Reserve Bank of New Zealand (RBNZ) Monitor has been the strongest of all our Monitors, and is currently well into "tight money required" territory" (Chart 9A). The solid New Zealand economic expansion has fully absorbed spare capacity, and both headline core inflation are accelerating towards the RBNZ target (Chart 9B). Both the inflation and growth components are surging, contributing to the overall sharp rise in the RBNZ Monitor (Chart 9C). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ So with growth and inflation looking perkier, why has the RBNZ not delivered on rate hikes this year? They central bank has highlighted "international uncertainties" related to geopolitical risks as well as trade tensions between China and the U.S. that could spill over into New Zealand exports to Asia. The central bank has also shown caution in its own growth and inflation forecasts, despite the signs of strength. Chart 9CHow Much Longer Can The RBNZ Ignore This? More likely, the RBNZ has been actively trying to avoid an unwanted surge in the currency that could derail the economy. Given the elevated geopolitical tensions with North Korea, it is likely that the RBNZ will stick with a dovish message - especially given the recent pickup in the currency. We have been running long positions in New Zealand government debt versus U.S. Treasuries and German Bunds in our Tactical Overlay portfolio since May. We've been heeding the commentary of the central bank rather than our own RBNZ Monitor, although the divergence between the two is becoming unsustainable (Chart 9D). The Q3 CPI inflation report due in October will be critical to assess the RBNZ's next move. We are sticking with our recommended trades, for now. Chart 9DNZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Fed vs. BoE: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. USTs vs. Gilts: Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklists: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Feature Inflation: Waking Up In The U.S., Peaking Out In The U.K. The bull market in risk assets remains powerful. Investors have shrugged off the worries about U.S. hurricanes and geopolitical tensions and have returned to focusing on the global growth and inflation backdrop. The fact that the S&P 500 could close at a new all-time high just above 2500 last Friday, shortly after another North Korean missile launch and a terrorist attack on the London Underground, speaks volumes about the renewed confidence (or is it hubris?) of investors. For bond markets, two events stood out - the firming read on August U.S. CPI inflation data and the surprisingly hawkish commentary from the Bank of England (BoE). We advise that investors pay more attention to the former and fade the latter. The U.S. inflation data is far more important, as it showed a decent rise in core inflation after five months of very weak prints (Chart of the Week). Chart of the WeekUSTs At Risk From A Rebound In Inflation A rebound in inflation is critical to our call for U.S. bond yields to rise over the next 6-12 months, as it would bring Fed rate hikes back into play. Right now, there is still a significant gap between market expectations for the fed funds rate by the end of 2018 and the current FOMC projection ("dot"). If the latest inflation data is the beginning of a sustained period of faster monthly price increases, then there is room for investors to reprice their expectations for both inflation and the funds rate (bottom two panels). There is a risk that the median FOMC rate projection for next year comes down a bit when the new "dots" are released after this week's FOMC meeting. Although with market-based inflation expectations firming, and survey-based measures holding steady near the Fed's 2% target amid easing financial conditions, the FOMC may choose to hold steady and wait to see if the August inflation data is the beginning of a trend - especially with the Fed set to announce the timing and details of the reduction of its balance sheet at this week's meeting. Downgrading interest rate expectations while also starting the unwind of the balance sheet could send a confusing message to markets. At the same time, any shift to a more hawkish or less dovish message from the Fed would be taken negatively by the Treasury market. The experience of Gilts last week is a warning sign about how unprepared investors are for a change in tone from central bankers. The language in the statement released after last week's BoE Monetary Policy Committee (MPC) meeting suggested that a rate hike may come within the next few months if U.K. economic growth evolves along the lines of the MPC's forecasts. That was enough to trigger a bear-flattening move in the Gilt curve, with the markets quickly pricing in one full additional rate hike by the BoE over the next year (Chart 2, second panel). A similar move could happen if the Fed were to send any new hawkish signals, although that is unlikely to occur at this week's FOMC meeting. We see a greater potential for the Fed's forecasts to be realized than the BoE's over the next year. Financial conditions have eased and leading indicators are still pointing to a reacceleration in U.S. growth in the coming months. The impact of the hurricanes in Texas and Florida will be a drag on growth in the 3rd quarter of this year, but this will not be enough to materially impact the Fed's growth forecasts for 2018. Meanwhile, the inflationary backdrop for the U.S. may finally be bottoming out, for a few reasons: 1. Our CPI diffusion index rising back above the 50 line in August (Chart 3, top panel), although additional gains will be necessary to herald a more sustained rise in core inflation. Chart 2Markets Have Bet Heavily##BR##On Central Bank Inaction Chart 3U.S. Inflation##BR##Stabilizing? 2. The U.S. labor market continues to tighten, with the gap between the "jobs plentiful" minus "jobs hard to get" indices from the Conference Board's consumer confidence survey widening to the widest level since 2001 (2nd panel), putting upward pressure on wage growth. 3. One of the biggest sources of the surprising downturn in core inflation seen in 2017, the plunge in wireless phone prices back in the spring, has fully stabilized (3rd panel). That decline alone represented a drag on the rate of inflation for core CPI services (excluding shelter) of 1.2 percentage points (bottom panel), and on overall core CPI inflation of around 35bps - ½ of the total decline in core CPI inflation since January. As the impact of that collapse in wireless charges falls out of the inflation data in the coming months, the drag on core CPI will fade. There is now a much better chance for the Fed's inflation forecasts to be realized next year, especially once the impact of a weaker dollar (and higher energy prices) is taken into account. While some of the doves on the FOMC may downgrade their inflation forecasts this week, a major reduction is unlikely in the absence of signs of a weakening U.S. labor market or renewed strength in the U.S. dollar. The U.S. backdrop contrasts sharply with what is going on in the U.K. While the labor market is even tighter there than in the U.S., the current upturn in U.K. inflation has also occurred alongside a sharp depreciation of the Pound since the 2016 Brexit vote (Chart 4). The currency has stabilized over the course of this year, with the year-over-year change in the BoE's trade-weighted index now nearly flat (bottom panel). Against this backdrop, inflation is more likely to peak out than reaccelerate from current levels. A similar argument can be made for the U.K. economy. Leading economic indicators have rolled over, while actual real GDP growth has decelerated (Chart 5, 3rd panel). Consumer confidence has steadily declined as the currency-driven inflation increase has eroded real income growth. This has created a very odd divergence between falling confidence and an increased market expectation for BoE rate hikes over the next year, which typically move in unison (bottom panel). Add in the ongoing uncertainties over Brexit that continue to weigh on business confidence and investment spending, and it is far more likely that the U.K. economy will lag versus the BoE's forecasts. Chart 4Currency Impact On U.K. Inflation Is Fading Chart 5Why Should The BoE Hike? For now, we are maintaining our recommended neutral allocation on Gilts in our model bond portfolio. Although we would view any additional widening in yield spreads between Gilts and U.S. Treasuries and core European yields as an opportunity to move to overweight. Simply put, the odds are far greater that the Fed's economic and inflation forecasts for the next year will be realized than those of the BoE, suggesting that there is more upside risk for yields in Treasuries than Gilts. Bottom Line: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklist Update Back in February of this year, we introduced a list of indicators we need to monitor to determine if our recommended defensive duration stance on U.S. Treasuries and German Bunds was still warranted.1 These "Duration Checklists" combined data on overall global growth, as well as U.S. and Euro Area economic activity, inflation, investor risk-seeking behavior and technical positioning on government bonds. At the time, the Checklists were almost unanimous in pointing to a period of rising bond yields based on an improving growth profile and slowly rising inflation pressures. We updated the Checklists in May and, for the most part, the majority of the indicators were still flagging more upward pressures on yields, although some series on global growth and inflation had softened.2 With the benefit of hindsight, we now know that these factors - especially the pullback in U.S. inflation pressures - were enough to trigger a significant bond rally. With the U.S. inflation downdraft now in the process of stabilizing, as discussed earlier, this is now a good opportunity to revisit our Duration Checklists to assess the current backdrop for bond yields. The broad conclusion is that the majority of the indicators are still pointing to higher bond yields in the months ahead (Table 1). Table 1A Bearish Message From Our Duration Checklists Global economic activity indicators are mixed, but may be bottoming. The global leading economic indicator (LEI) continues to rise, heralding a continuation of the current economic uptrend (Chart 6). The breadth of that advance, however, is fading with our LEI diffusion index having fallen below the 50 line, meaning that there are more countries with a falling LEI. The global ZEW indicator of investor sentiment is also trending downward, another factor weighing on yields. The near-term dynamics on growth are starting to shift more bearishly for bonds, however, with the global data surprise index rising and the latest read on our Global Credit Impulse indicator ticking upward. We are giving a "check" to 3 of the 5 global growth elements in our Duration Checklists (LEI, data surprises, Credit Impulse), which represents a bond-bearish shift from the last update of the Checklists in May when only the LEI warranted a "check". Domestic economic growth in the U.S. and Euro Area is solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe are rising, as is consumer and business confidence (Charts 7 & 8). The latter is not surprising given the strong growth in corporate profits on both sides of the Atlantic that our models expect will continue. This bodes well for future growth momentum, as firms will not be forced to retrench on hiring and investment spending to protect profitability. We are giving a "check" to all domestic growth components of our Duration Checklists, highlighting that the economic backdrop remains bond bearish. Chart 6Yields Are Exposed To##BR##Improving Global Growth Chart 7A Solid U.S.##BR##Economic Expansion Chart 8European Growth Momentum##BR##Is Bearish For Bunds Realized inflation has dipped, but the worst looks to be over. In our Checklists, we include measures on energy prices, labor market tightness and wage inflation as the primary inflation indicators to monitor. On that front, the story still looks fairly benign for U.S. inflation given the dip in wage inflation measures like Average Hourly Earnings growth and the Atlanta Fed Wage Tracker (Chart 9). The unemployment gap (unemployment rate vs. NAIRU) is still negative, and other wage measures like the wage & salaries component Employment Cost Index are steadily expanding, suggesting that the underlying wage dynamics in the U.S. may not be as slow as indicated by Average Hourly Earnings. In the Euro Area, wage growth has accelerated above 2%, occurring alongside a grinding increase in core inflation and an unemployment gap that is almost fully closed (Chart 10). Meanwhile, the downward momentum in the growth of energy prices - denominated in both dollars and euros - has bottomed out after the sharp decline since the beginning of the year, although the rebound has been tepid so far (top panel of Charts 9 & 10). Chart 9Not Much Inflationary##BR##Pressures On UST Yields Chart 10Core Inflation & Wages Are##BR##Grinding Higher In Europe The most significant divergences between the regions exist within the inflation elements of our Checklists. For wage growth, we are giving an "x" to the U.S. but a "check" to Europe. For the unemployment gap, we are giving a "check" to both regions. For energy prices, however, we are not giving any indication (a "?") until we see more decisive evidence of a sustained acceleration that is pressuring headline inflation rates even higher. Both the Fed and ECB are biased to remove monetary accommodation. The Fed is in the midst of a rate-hiking cycle that began in late 2015, and is now about to begin the long process of shrinking its swollen balance sheet. The ECB has been slowly preparing the market for a shift to a slower pace of asset purchases, although rate hikes are still at least a couple of years away. For both central banks, we are giving a "check" for having a more hawkish/less dovish policy bias that is not bullish for bonds. Investors remain in risk-seeking mode. The way that we interpret investor risk aversion in the Checklists is if growth-sensitive risk assets like equities and corporate credit are rallying, then this is bearish for government bonds. The logic here is that private investor demand for Treasuries and Bunds is diminished when risk assets are rallying, as long as equities are not stretched to a point where the risks of a correction are elevated (i.e. indices trading 10% above their 200-day moving average). Also, the easing of financial conditions stemming from rallying stock and credit markets is a boost to growth that central banks will likely respond to by becoming less accommodative. From that perspective, the persistent bull markets in equities and corporate credit on both sides of the Atlantic are bearish for Treasuries (Chart 11) and Bunds (Chart 12). With stocks not looking stretched versus the medium-term trend and with volatility remaining low, all the related elements of our Checklists earn a "check". Chart 11Still A Pro-Risk Bias##BR##Among U.S. Investors Chart 12Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond yields do not look stretched to the upside from a technical perspective. The Treasury sell-off from the 2017 peak back in March has pushed the 10-year yield back below its 200-day moving average, while also boosting the 6-month total return into positive territory (Chart 13). There is also a persistent net long position in 10-year Treasury futures (bottom panel). Add it all up and the technical backdrop for Treasuries is stretched in a way pointing to greater near-term risks of higher yields. In Europe, momentum measures all look neutral (Chart 14) and are no impediment to rising yields. We give all technical elements of our Duration Checklists a "check". Chart 13UST Rally Since March##BR##Is Looking Stretched Chart 14Neutral Technical##BR##Backdrop For Bunds Net-net, the Checklists show that the majority of indicators are still pointing to a bond-bearish backdrop. The only bond-bullish factors are the soft inflation readings in the U.S. although that may be in the process of shifting, as discussed earlier. There is not a major difference in the number of checkmarks for both the U.S. and Euro Area Checklists, thus we see no reason to favor either market from a relative perspective - there is pressure for both Treasury and Bund yields to rise. Thus, we are maintaining our recommended below-benchmark medium-term duration stance in both the U.S. and core Europe within hedged global bond portfolios. Chart 15UST Yields Have More Near-Term Upside From a shorter-term tactical perspective, however, we see more upside for Treasury yields vs Bunds with U.S. economic data surprising to the upside at a faster pace than in Europe (Chart 15). Throw in the potential for U.S. inflation to also rise above depressed expectations and a wider Treasury-Bund spread - a trade that we currently have in our Tactical Overlay portfolio and which goes against the tightening currently priced into the forwards - is the more likely outcome in the next few months. Bottom Line: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Fade The "Trump Fade"", dated May 23rd 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Chart 3Consumer Spending And##BR##Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Chart 9High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.
Highlights Some caution warranted here. Hurricane Harvey's impact on the economy and markets. Tensions in North Korea will linger. NIPA and S&P now telling same story on profits, margins. Is the August employment report enough for the Fed? Feature The impact of Hurricane Harvey will ripple through the economic data in the coming months, but will not impact the overall trajectory of the economy or the Fed. However, elevated equity valuations, escalating tensions in North Korea, a widening disconnect between the bond market and the Fed and profit growth that is poised to peak in the second half of the year warrants careful attention from investors. Nonetheless, we remain slightly overweight stocks and favor stocks over bonds. Caution On Risk Assets We recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasuries, Swiss bonds and JGBs were the best performers during a crisis (Chart 1). The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Chart 1Gold Loves Geopolitical Crises Gold tends to perform well in geopolitical events, although not in recessions or financial crunches. Our base case projects stocks outperforming cash and bonds over the next 6-12 months. BCA's dollar and duration positions have disappointed so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the stance that structural headwinds to inflation will forever dominate the cyclical pressures. Therefore, the bond market is totally unprepared for any upside shocks on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to be predominantly to the upside. Harvey's Lingering Aftermath History shows that natural disasters such as Hurricane Harvey have a temporary effect on the U.S. economy, the financial markets and the Fed. Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the record rainfall and flooding in Houston. Chart 2 shows the ranking of Harvey's preliminary damage estimate of $30B versus other storms of similar magnitude. We are still several weeks away from the peak of the Atlantic hurricane season (mid-September) and two of the most destructive storms in the past 25 years made landfall in mid-to-late October (Wilma and Sandy). Chart 2Economic Impact From Major Hurricanes Chart 3 shows the performance of key economic, inflation and financial market indicators in the past two years and also around five major hurricanes since 1992. Most of the activity-related economic statistics are volatile in the aftermath of the storms and then they recover. The Citi economic surprise index initially moves higher after a storm, and then fades (Chart 3A). There are big swings in housing starts and industrial production and employment growth slows. Inflation tends to climb post-landfall (Chart 3B). In prior episodes, core PCE and core CPI have accelerated along with gasoline prices. Consumer confidence dips initially, but then recovers. Wages are volatile, but tend to accelerate after several months. Chart 3C shows that stocks drift lower for several months following hurricanes and subsequently recoup the losses. The stock-to-bond ratio also moved lower, but regains its pre-storm heights about two months later. Treasury yields fall after storms, but we note that yields have been in a secular decline for 25 years. Chart 3AMajor Hurricane Impact##BR##On Activity Data Chart 3BMajor Hurricane Impact On##BR##Sentiment And Inflation Data Chart 3CMajor Hurricane Impact On##BR##Financial Markets & The Fed Hurricane Harvey will not shake the Fed. Nonetheless, the central bank will acknowledge the disaster in the FOMC statement, the FOMC minutes, and/or in Fed Chair Janet Yellen's news conference. We are unchanged in our view that policymakers will begin to pare its balance sheet later this month and bump up rates again in December, assuming that core inflation shows some signs of strength between now and then. History shows (Chart 3C) that, on average, the Fed funds rate tends to move higher in the months after storms hit, but the primary message is that the Fed just continues to do whatever it was doing before the storm. The Fed cut rates in the aftermath of Hurricane Andrew in 1992 in what turned out to be the final rate reduction of the cycle that began in 1989. Ivan hit in September 2004, but the monetary authority raised rates in the final three FOMC meetings of 2004, including at the meeting only a week after the hurricane made landfall. Similarly, the Fed clung to its rate hike regime after Wilma in October 2005. In 2008, Ike arrived in Texas two days before Lehman Brothers collapsed in mid-September. The Fed, which had been cutting rates since September 2007, lowered rates in the final months of 2008. The Fed announced QE3 in late summer 2012 and continued with the program after Sandy came ashore at the end of October 2012. Harvey will be a game changer in some respects: the devastation reduces the odds of a government shutdown or of failing to increase the debt ceiling. We have maintained that there were extremely low odds that the debt ceiling would not be raised. We stated that there was a 25% chance of a government shutdown between October 1, when the current funding expires, and sometime in mid-October when the debt ceiling will hit according to the Congressional Budget Office. However, it would be unfathomable to shut down the government and force the Federal Emergency Management Agency (FEMA) to cease operations. The resulting outrage would damage the Republicans, especially in Texas. Bottom Line: Harvey may have a near-term impact on the economy, but the Fed will stick to its plan. The catastrophe makes it increasingly likely that the debt ceiling will be raised and a resolution will be passed to keep the government operating into the new fiscal year. Thus, equity investors can safely ignore these two risks, and focus on the key risk in the outlook: North Korea. North Korea Could Linger Over Markets BCA believes that the probability of a war on the Korean Peninsula is very low,1 but it may take a while before the uncertainty in Northeast Asia is resolved. Between now (escalating tensions) and then (a negotiated settlement), there will be more provocations and market volatility. There are long-standing constraints to war. The first is a potentially high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage. Furthermore, U.S. troops, and Japanese forces and civilians, would also suffer. Secondly, China is unlikely to remain neutral. Strategically, China will not tolerate a U.S. presence on its border with North Korea. Nevertheless, Washington must establish a credible threat of military action if it is to convince Pyongyang that negotiations offer a superior outcome. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is credible. Chart 4 shows the arc of diplomacy2 that the U.S. took with Iran between 2010 and 2014. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this territorial threat display or evidence of real preparations for an actual attack. More market volatility may occur, but for the time being, we do not think that the tensions in the Korean peninsula will end the bull market in global equities. Positions in traditional safe-haven assets, such as gold, U.S. Treasuries, Swiss francs and (perhaps) Japanese yen, should be considered as hedges against increased market swings. Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Update: Equity Valuations, Sentiment And Technicals U.S. equity valuations are stretched, but elevated valuations alone are not enough to prompt a sell-off in stocks. The BCA valuation indicator is in overvalued territory, where it has been since late 2013. History shows3 that stocks can stay overvalued for extended periods, even when the Fed is raising rates, but policy is still accommodative as it is today. BCA's composite valuation indicator is still shy of the +1 standard deviation level that defines extremely over-valued (Chart 5). However, this is due to the components that compare equity prices with bond yields. The other three elements of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched (Chart 5 panels 2, 3 and 4). That said, equities are attractively priced relative to competing assets, such as corporate bonds and Treasuries (Chart 6). Chart 5U.S. Equities##BR##Are Overvalued... Chart 6...But Look Less Expensive##BR##Relative To Competing Assets Valuation is not a reliable tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we do not forecast a sustained pullback in stocks. Looking beyond BCA's tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Chart 7No Strong Signal From##BR##Sentiment Or Technicals BCA's technical and sentiment indicators are not at extremes (Chart 7). The BCA technical indicator, while above zero, is not at a level that in the past has triggered a stock pullback. Similarly, the BCA investor sentiment composite index, while at the top end of its bull market range, is not at an extreme. Moreover, only 50% of the stocks in the NYSE composite are above their 10-week moving average, a level which has not been previously associated with major equity sell-offs. Bottom Line: The solid earnings backdrop remains in place for U.S. stocks as measured by either the S&P or the national accounts. We anticipate that profit growth has peaked according to S&P 500 data on a 4-quarter moving total basis due to tough comparisons although it will slip only modestly in the second half of the year. Next year will see EPS growth drop back into the mid-single digit range. The consensus estimate for 2018 EPS growth is 11%. While valuations are elevated, neither sentiment nor technical indicators are flashing red. We recommend stocks over bonds in the next 6-12 months, but acknowledge that risks to BCA's stance are climbing. A Reconnection In Q2 The Q2 data show that the NIPA and S&P earnings measures have reconnected. In our July 3, 2017 Weekly Report "Summer Stress Out"4 we highlighted the apparent disconnect between the S&P and NIPA, sales earnings and margin data through Q1 2017. The release of the Q2 corporate profits data in the national accounts and the end the Q2 S&P 500 reporting season allow us to provide an update. The year-over-year reading on the NIPA earnings measure ticked up in Q2 while the S&P-based metric ticked down. That said, while there are marked differences in annual growth rates between the two measures, the levels were close to the same point in the second quarter of 2017 (Chart 8, bottom panel). Chart 9 shows that a wide difference persists between corporate sales measured by S&P and the national accounts. Margins calculated on the S&P basis climbed in Q2 while NIPA margins held steady. Even so, a modest gap still remains between NIPA margins at 15.2% and S&P margins at 13.2%. Most of the divergence is related to the denominator of the calculation. The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. Chart 8S&P And NIPA##BR##Profit Comparison Chart 9Denominator Explains##BR##S&P/NIPA Margin Divergence We believe that the S&P statistics are painting a more accurate picture because sales are easier to measure while value-added is more complicated. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P readings are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop is positive for stocks for now. Is The August Jobs Report Enough For The Fed? Chart 10Labor Market Conditions##BR##Favor Risk Assets U.S. payrolls expanded by 156,000 in August. Relative to the underlying growth rate in the labor force, this is still a healthy pace of jobs growth. Nevertheless, it fell short of expectations for a 180,000 increase and the prior two months saw a cumulative downward revision of 41,000. The August data were not impacted by Hurricane Harvey. Aggregate hours worked, a measure of total labor inputs based on changes in employment and the workweek, fell by 0.2% m/m. That said, aggregate hours worked are up 1.3% at a quarterly annualized rate thus far in Q3. This is consistent with GDP growth of a bit over 2%, which has been the trend in the current economic expansion. Meanwhile, wage gains remain muted. Average hourly earnings rose just 0.1% m/m. Annual wage inflation has been steady at 2.5% for several months now (Chart 10, bottom panel). If productivity is expanding modestly around 1%, the current pace of wage gains would suggest that unit labor costs are growing around 1.5%. This will make it difficult for general price inflation to accelerate to the Fed 2% target. Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.6% in August supports the Fed's view on inflation. Finally, the unemployment rate ticked up to 4.4% from 4.3%. This was because the separate household survey showed a 74,000 drop in employment. The participation rate held steady at 62.9% in August. Bottom Line: While falling short of expectations in August, U.S. employment growth remains solid and job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. However, muted wage gains mean that progress to the Fed's 2% inflation target is looking suspect. We anticipate that the Fed will announce the process of running down its balance sheet at the September FOMC meeting. Rate hikes are on hold at least until the December FOMC meeting, and even then only if core inflation shows some signs of strength in the next few months. U.S. risk assets should continue to benefit from moderate growth, low inflation and a "go slow" approach by the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. It is available at gps.bcaresearch.com. 2 Please see BCA's Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets? ,"May 24, 2017, available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Sizing Up The Second Half", July 10, 2017, available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017, available at usis.bcaresearch.com.
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. 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 29th, 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 August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. 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 Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 Chart 2BGlobal Asset Valuations, 1990-2017 Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index