Corporate Bonds
Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends Chart II-2Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM Chart II-5Bottom-Up HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta Chart II-8Interest Coverage Ratio Vs. Earnings Beta Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.
Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. 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. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Global equities are technically overbought, making them highly vulnerable to a correction. The cyclical picture for stocks still looks good, thanks to strong economic growth and rising corporate profits, but the recent spike in bond yields is becoming a headwind. Valuations are highly stretched, particularly in the U.S. This points to subpar long-term returns. On balance, we recommend staying overweight global equities. However, investors should consider buying some insurance against a market selloff. The VIX has probably bottomed for this cycle and high-yield spreads are unlikely to move much lower. This makes long volatility and short credit positions attractive hedges. Going short AUD/JPY is also an appealing hedge, given the yen's defensive characteristics and the Aussie dollar's vulnerability to slower Chinese growth. We were stopped out of our long global industrials versus utilities trade for a gain of 12%. We are also raising our stop on our short fed funds futures trade to 70 bps. Feature A Cloudy Picture As a rule of thumb, technical factors drive stocks over short-term horizons of one-to-three months, business cycle developments and financial conditions drive stocks over horizons of one-to-two years, and valuations drive stocks over ultra long-term horizons of five years and beyond. Occasionally, all three sets of signals line up in the same direction. In March 2009, the combination of bombed-out sentiment, cheap valuations, green shoots in the economy, and the expansion of the Fed's QE program all aligned to mark the beginning of a powerful bull market in stocks. Unfortunately, today the calculus is not so simple. Stocks Are Technically Overbought Technically, the stock market has gotten ahead of itself. The S&P 500 Relative Strength Index hit a record high earlier this week, while our Technical Indicator reached a post-recession high (Chart 1). The S&P has now gone 310 days without a 3% drawdown and 402 days without a 5% drawdown - both records (Chart 2). Chart 1U.S. Equities Are Technically Overbought Chart 2It's Been A Long Time Since U.S. Stocks Corrected Irrational exuberance is back. Our Composite Sentiment Indicator has jumped to the highest level since right before the 1987 crash (Chart 3). Retail investors are also flooding back into the market. Discount brokers such as E*TRADE and Ameritrade have seen a flurry of activity (Chart 4).The latest monthly survey conducted by the American Association of Individual Investors showed that respondents had the largest allocation to stocks since 2000 (Chart 5). Chart 3Equity Investors Are Mega-Bullish Chart 4Retail Investors Have Piled In (Part I) Chart 5Retail Investors Have Piled In (Part II) The Economy And Earnings Still Paint A Bullish Backdrop Chart 6Economic Outlook Remains Solid In contrast to the ominous technical picture, the cyclical outlook for stocks looks reasonably solid (Chart 6). The Citigroup Economic Surprise Index for major advanced economies has risen to near record-high levels. Goldman's Global Current Activity Indicator stands close to a cycle high of 5%, up from 2.2% at the start of 2016. Our Global Leading Indicator has decelerated somewhat, but is still pointing to above-trend growth this year. Growth in the euro area remains strong. The economy grew by 2.5% in 2017, the fastest pace since 2007. U.S. growth is gathering steam. Real private final demand increased by 4.6% in Q4. The Atlanta Fed's GDPNow model is signaling growth of 5.4% in the first quarter, while the New York Fed Staff Nowcast is pointing to a more plausible growth rate of 3.1%. Reflecting the strong economy, corporate profits are ripping higher. 45% of S&P 500 companies have reported 2017 Q4 results. 80% have beaten consensus EPS projections, above the long-term average of 69%. 82% have beaten revenue projections, which also exceeds the long-term average of 56%. The fact that earnings and revenue have surprised so strongly to the upside is all the more impressive given the sharp increase in EPS estimates over the past few months (Chart 7). Moreover, the improvement in earnings has been broad-based across sectors (Table 1). Chart 7Analysts Scramble To Revise 2018 Earnings Estimates Higher Table 1Estimated Earnings Growth For 2018 Financial Conditions Are Supportive, But Rising Bond Yields Are A Risk Financial and monetary conditions remain accommodative, as judged by an assortment of financial conditions indices (Chart 8). The global credit impulse has surged (Chart 9). Chart 8Financial Conditions Have Eased Chart 9Global Credit Impulse Is Positive The recent rapid ascent in global bond yields complicates matters. So far, much of the increase in yields has been driven by higher inflation expectations. This has kept real yields down. Indeed, real 2-year yields have actually declined in the euro area and Japan over the last several months. In absolute terms, yields are still low by historic standards (Chart 10). As my colleague Doug Peta, who heads our Global ETF Strategy service, has documented, rising bond yields pose a bigger problem for the economy and risk assets when they move into restrictive territory (Table 2). We are not there yet (Chart 11). Stronger global growth and diminished spare capacity have pushed up the pain threshold for when rising bond yields begin to bite. In the U.S., fiscal stimulus and a cheaper dollar have also caused the neutral rate to rise. Chart 10Yields Are Still Low ##br## By Historic Standards Table 2Aggregate Real S&P 500 Returns ##br## During Rate Cycle Phases From August 1961 Chart 11Rates Not Hurting ... Yet Nevertheless, equities often struggle to digest rapid increases in bond yields. Although the late 2016 episode stands out as an exception, stocks have typically floundered following an increase in global bond yields of around 50 bps (Table 3). The yield on the JP Morgan Global Government Bond index has risen by 27 bps since last autumn. If yields continue their swift ascent, stocks could come under pressure. Table 3What Happens When Bond Yields Spike? Valuation Concerns Chart 12Demanding U.S. Valuations Point To Low Long-Term Returns Valuations are not much use for timing the stock market, but they are the most important driver of returns over the long haul. Chart 12 shows the close correlation between the Shiller P/E ratio in the U.S. and the subsequent 10-year total return for stocks. Even though realized earnings growth tends to be higher following periods when the P/E ratio is elevated, this is more than offset by a lower dividend yield and the compression of P/E multiples. Today's Shiller P/E ratio of 34 presages subpar returns over the next decade. The picture is somewhat better outside the U.S. Our composite valuation measure - which combines trailing P/E, price-to-sales, price-to-book, Tobin's Q, and market capitalization-to-GDP - suggests that most stock markets outside the U.S. will see returns in the low-to-mid single-digit range over the next ten years (Appendix 1). Nevertheless, this is still well below the historic average return for these markets. What To Do? Our cyclical overweight in global equities has worked out well, and barring evidence that the global economy is tipping into recession, we intend to maintain this recommendation. Nevertheless, the discussion above suggests that stocks are vulnerable to a near-term correction and that long-term returns are likely to be lackluster at best. As such, it is sensible to take out some insurance against a market selloff. The question, as always, is how to guard against a drop in equity prices without suffering too much of a drag if global bourses continue to grind higher. We noted three weeks ago that today's equity bull market is starting to look increasingly like the one in the late 1990s.1 Back then, rising equity prices were accompanied by both higher volatility and wider credit spreads (Chart 13). History seems to be repeating itself. The VIX bottomed on November 24 at 8.56 and ended last week at 11.08, even as the S&P 500 hit another record high. Investors should consider buying volatility futures on any major dip in the VIX. Junk bonds have also underperformed equities year-to-date, which has benefited our long S&P 500/short high-yield credit recommendation. As we go to press, the Barclays high-yield total return index is flat for the year, while the S&P 500 has gained 5.7%. Given the deterioration in our Corporate Health Monitor, and the likelihood that rising inflation will keep Treasury yields in an uptrend, investors should consider hedging equity risk by shorting junk bonds. Chart 13Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Chart 14Chinese Growth Is Decelerating Moderately Go Short AUD/JPY Chart 15Iron Ore Stockpiles Are Hitting New Highs In China Going short the Australian dollar versus the Japanese yen is also an appealing hedge against a broad-based retreat from risk assets. The yen is a highly defensive currency. Japan has a healthy current account surplus of 4% of GDP. Its accumulated foreign assets outstrip foreign liabilities by a whopping 65% of GDP. When Japanese investors get nervous about the world and start repatriating funds back home, the yen invariably strengthens. The Aussie dollar is highly levered to the Chinese economy. While we do not expect a steep deceleration in Chinese growth this year, we do think that growth will fall from last year's heady pace. This can already be seen in the deterioration in the Li Keqiang index (Chart 14). The growth rate of railway freight, one of the index's components, has fallen from above 20% in early 2017 to -1%. Crucially for Australia, iron ore stockpiles in Chinese ports are hitting record highs (Chart 15). Meanwhile, the Reserve Bank of Australia's commodity index has rolled over. The year-over-year change in the index has dropped from a high of 47% six months ago to -1%. Domestically, the output gap stands at 2% of GDP. Both core CPI inflation and wage growth remain subdued (Chart 16). The household saving rate has dropped to 3%, while debt levels have reached nosebleed levels (Chart 17). This will limit consumer spending. Business confidence has dipped recently, as has the PMI new orders index (Chart 18). Mining capex has been trending lower, falling from over 6% of GDP in 2012 to 2.1% of GDP in 2017. The Australian government expects mining capex to sink further to 1.3% of GDP in 2018 (Chart 19). All this will limit the RBA's ability to hike rates. Chart 16Australian Core CPI Inflation And Wage Growth Remain Subdued Chart 17Australian Household Debt At Unsustainable Levels Chart 18Australia: Business Confidence And Orders Have Dipped Chart 19Mining Capex To Fall Further From a valuation perspective, AUD/JPY currently trades at a 27% premium to its Purchasing Power Parity exchange rate, having traded at a discount of as much as 50% back in 2000 (Chart 20). Speculators are heavily short the yen right now. As my colleague Mathieu Savary has noted, this could supercharge any short covering rally.2 Higher asset market volatility should also weaken the Aussie dollar. Chart 21 shows that AUD/JPY tends to be inversely correlated with the CVIX, an index of currency volatility. Chart 20AUD/JPY Trading At A Premium Chart 21Higher Vol Will Weaken AUD With this in mind, we are opening a new tactical trade recommendation to go short AUD/JPY. As a housekeeping matter, we are closing our long AUD/NZD trade for a loss of 1.8%. We were also stopped out of our long global industrial stocks versus utilities trade for a gain of 12%. Lastly, we are raising our stop on our short fed funds futures trade to 70 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Will Bitcoin be Defanged," dated January 12, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!," dated January 12, 2018, available at fes.bcaresearch.com Appendix 1 Chart A1Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity Chart II-10U.S.: Unit Labor Costs Vs. Robot Density In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density Chart II-16Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights A thorough audit of our trade book highlights that our country and sector allocation recommendations have been quite profitable for investors. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return. A review of the original basis and subsequent performance of our trades suggests that investors should close 6 out of 12 of our active positions, predominantly related to resource & construction and domestic stock market themes. We will be looking for opportunities to add new trades to our book over the coming weeks and months that have broad, "big-picture" relevance. Watch this space. Feature In this week's report we conduct a thorough audit of our trade book, by revisiting the original basis and subsequent performance of all 12 of our active trades. While these trades have been initiated at different points over the past five years, they can be broadly grouped into five different themes: Core Equity Allocation & General Pro-Risk Trades (4 Trades) Reform-Oriented Trades (2 Trades) Resource & Construction Plays (2 Trades) Domestic Stock Market Trades (2 Trades) Trades Linked To Hong Kong (2 Trades) Overall, our trade book performance has been excellent. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return (since December 2015). As a result of our trade book review, we recommend that investors close six trades and maintain six over the coming 6-12 months. The closed trades predominantly fall into the resource & construction and domestic stock market categories, although we also recommend closing our long China H-share / short industrial commodity trade as well as our long Hong Kong REITs / short Hong Kong broad market trade. We present our rationale for retaining or closing each trade below. Over the coming weeks and months we will be looking for opportunities to add new trades to our book. Stay tuned. Core Equity Allocation & General Pro-Risk Trades We have four open core equity allocation and pro-risk trades: Overweight MSCI China Investable stocks versus the emerging markets benchmark, initiated on May 2, 2012 Long China H-shares / short industrial commodities, initiated on March 16, 2016 Short MSCI Taiwan / Long MSCI China Investable, initiated on February 2, 2017 and Long China onshore corporate bonds, initiated on June 22, 2017 We recommend that investors stick with three of these trades, but close the long China H-shares / short industrial commodities position for the following reasons: Chart 1Be Overweight China Vs EM In This Environment Overweight MSCI China Investable Stocks Versus The EM Benchmark (Maintain) This trade represents one of the most important equity allocation calls for Chinese stocks, and is one of the ways that BCA expresses a view on the Chinese economy in our House View Matrix.1 While it hasn't always been the case, we noted in a recent Special Report that Chinese stocks have become a high-beta equity market versus both the global aggregate and the emerging market benchmark, even when excluding the technology sector.2 China's high-beta nature, the fact that EM equities remain in an uptrend (Chart 1), and our view that China's ongoing slowdown is likely to be benign and controlled all suggest that investors should continue to overweight Chinese stocks vs their emerging market peers. Long China H-Shares / Short Industrial Commodities (Close) We initiated this trade in March 2016, one month after Chinese stock prices bottomed following the significant economic slowdown in 2015. At that time it was not clear to global investors that a mini-cycle upswing in the Chinese economy had begun, and this pair trade was a way of taking a limited pro-risk bet. Given our view of a benign, controlled economic slowdown in China, this hedged trade is no longer needed, especially given the uncertain impact of ongoing supply side constraints in China on global commodity prices. As such, we recommend that investors close the trade, locking in an annualized return of 15.7%. Short MSCI Taiwan / Long MSCI China Investable (Maintain) Chart 2If The TWD Declines Materially, ##br##Upgrade Taiwan (From Short) We initiated our short MSCI Taiwan / long MSCI China investable trade last February, when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). We reviewed the basis of this trade in a report last month,3 and recommended that investors stick with the call despite significantly oversold conditions (Chart 2). A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. Long China Onshore Corporate Bonds (Maintain) Chinese corporate bond yields have risen materially since late-2016, largely in response to expectations of tighter monetary policy. These expectations have been validated, with 3-month interbank rates having risen over 200bps since late-2016. We argued last summer that the phase of maximum liquidity tightening was likely over, and that quality spreads and government bond yields would probably drop over the coming three to six months. While this clearly did not occur (yields and spreads rose), the total return from this trade has remained in the black owing to the significant yield advantage of these bonds versus similarly-rated bonds in the developed world. Chart 3 highlights that Chinese 5-year corporate bond spreads are also considerably less correlated with equity prices than their investment-grade peers in the U.S. This underscores that the rise in yields and spreads over the past year has reflected expectations of tighter monetary policy, not rising default risk. Our sense is that barring a significant improvement in China's growth momentum, significant further monetary policy tightening is improbable, meaning that corporate bond yields are not likely to rise much further. As a final point, as of today's report we are changing the benchmark for this trade from a BCA calculation based on a basket of 5-year AAA and AA-rated corporate bonds to the ChinaBond Corporate Credit Bond Total Return Index. Chart 3Chinese Corporate Spreads Aren't A Risk ##br##Barometer Like In The U.S. Reform-Oriented Trades We have two open trades related to China's rebooted reform initiative, both of which were initiated on November 16, 2017: Long China investable consumer staples / short consumer discretionary stocks and Long China investable environmental and social governance (ESG) leaders / short investable broad market These trades were recently opened, and we continue to recommend that investors maintain both positions: Long China Investable Consumer Staples / Short Consumer Discretionary Stocks (Maintain) The basis for the first trade stems from the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. We argued in our November 16 Weekly Report that Chinese investable consumer staples would be a better play on Chinese consumer spending owing to the material weight of the automobiles & components industry group in the discretionary sector, which may fare poorly over the coming year due to the environmental mandate of President Xi's proposed reforms. We argued in the report that this trade would likely be driven by alpha rather than beta, and indeed Chart 4 illustrates that staples continue to rise relative to discretionary against a backdrop of a rising broad market. Long China Investable ESG leaders / Short Investable Broad Market (Maintain) In the same report we recommended that investors overweight the China investable ESG leaders index, based on the goal of favoring firms that are best positioned to deliver "sustainable" growth in an era of heightened environmental reforms. The index overweights firms with the highest MSCI ESG ratings in each sector (using a proprietary MSCI ranking scheme), and maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that the trade is progressing in line with our expectations, suggesting that investors stick with the position over the coming 6-12 months. Chart 4Staples Vs Discretionary Isn't A Low Beta Trade Chart 5Likely To Continue To Outperform Resource & Construction Plays We have two open trades related to the resource sector: Long China investable oil & gas stocks / short global oil & gas stocks, initiated on April 26, 2014 and Long China investable construction materials sector / short investable broad market, initiated on December 9, 2015 We recommend that investors close both of these positions, based on the following rationale: Chart 6Similar Earnings Profile, ##br##But Weaker Dividend Payouts Long China Investable Oil & Gas Stocks / Short Global Oil & Gas Stocks (Close) This trade was initiated based on the view that the valuation gap between Chinese and global oil & gas companies is unjustifiable given that the earnings off both sectors are globally driven. Indeed, Chart 6 shows that the trailing EPS profiles of both sectors in US$ terms have been broadly similar over the past few years, and yet China's oil & gas sector trades at a 40% price-to-book discount relative to its global peers. However, panel 2 of Chart 6 highlights that this discount may represent investor concerns about earnings quality and/or state-owned corporate governance. The chart shows that while the earnings ROE for Chinese oil & gas companies is higher than that of the global average, the dividend ROE (dividends per share as a percent of shareholders equity) is considerably lower. While China's oil & gas dividend ROE has recently been rising, the gap remains wide relative to global oil & gas companies, suggesting that there is no significant re-rating catalyst that is likely to emerge over the coming 6-12 months. Close for an annualized return of 1.4%. Long China Investable Construction Material Stocks / Short China Investable Broad Market (Close) The relative performance of Chinese investable construction material stocks has been positive over the past two years, with the trade having generated an 8.1% annualized return since initiation. There are two factors contributing to our view that it is time for investors to book profits on this trade. The first is that China's investable construction materials are dominated by cement companies, which may suffer in relative terms from China's rebooted reform initiative this year.4 The second is that the relative performance of construction materials stocks is closely correlated with, and led by, the growth in total real estate investment (Chart 7). Residential investment makes up a significant component of total real estate investment, and Chart 8 highlights that a significant gap between floor space sold and completed has narrowed the inventory to sales ratio over the past three years. But the ratio remains somewhat elevated relative to its history which, when coupled with the ongoing growth slowdown in China and the deceleration in total real estate investment growth, implies a poor risk/reward ratio over the coming 6-12 months. Chart 7Cement Producers Trade Off Of Real Estate Investment Chart 8No Clear Construction Boom Is Imminent Domestic Stock Market Trades We have two open trades related to China's domestic stock market: Long China domestic utility sector / short domestic broad market, initiated on January 22, 2014 and Long China domestic food & beverage sector / short domestic broad market, initiated on December 9, 2015 Similar to our resource & construction plays, we recommend that investors close both of our recommended domestic stock market trades: Long China Domestic Utility Sector / Short Domestic Broad Market (Close) We initiated this trade in early-2014, following a comprehensive reform plan released in late-2013 by the Chinese government. The plan called for allowing market forces to play a decisive role in allocating resources, which we argued would grant utilities more pricing power, reduce their earnings volatility associated with policy risks, and lead to a structural positive re-rating. Chart 9 illustrates that this trade gained significant ground in 2014 and early-2015, even prior to the significant melt-up in domestic stock prices that began in Q2 2015. However, the trade has underperformed significantly since the middle of last year, which has been driven by a sharp deterioration in ROE. This decline in ROE appears to have been cost-driven, as coal is an important feedstock for Chinese utility companies and has risen substantially in price over the past two years. While domestic utilities are now significantly oversold in relative terms, we recommend that investors close this trade because the original reform-oriented basis has shifted significantly. The priorities that emanated from October's Party Congress were decidedly environmental in nature, meaning that coal prices may very well remain elevated over the coming 6-12 months (due to restricted supply). This means that a recovery in ROE would rest on the need to raise utility prices, which is a low-visibility event that will be difficult to predict. Close for an annualized return of 3%. Long China Domestic Food & Beverage Sector / Short Domestic Broad Market (Close) We initiated this trade in December 2015, based on this sector's superior corporate fundamentals and undemanding valuation levels. We argued that the anti-corruption campaign since late-2012 was likely the cause of prior underperformance, given that the group is dominated by a few high-end alcohol producers. The market overacted to the high-profile crackdown, and ultimately the fundamentals of the sector did not deteriorate materially. Our view has panned out spectacularly, with the trade having earned a 32% annualized return since inception5 (Chart 10 panel 1). While the group's ROE remains significantly above that of the domestic benchmark, valuation measures suggest that investors have more than priced this in (Chart 10 panel 2). The trade has mostly played out and we would not like to overstay our welcome. In addition, panel 3 illustrates that technical conditions are extremely overbought, suggesting that investors are being presented with an excellent opportunity to exit the position. Chart 9Sidelined By A Major Hit To ROE Chart 10Time To Book Profits Trades Linked To Hong Kong We have two open trades related to Hong Kong: Long U.S. / short Hong Kong 10-Year government bonds, initiated on January 15, 2014 and Short Hong Kong property investors / long Hong Kong broad market, initiated on January 21, 2015 We recommend that investors stick with the first and close the second, based on the following perspectives: Long U.S. / Short Hong Kong 10-Year Government Bonds (Maintain) Hong Kong has an open capital account and an exchange rate pegged to the U.S. dollar, meaning that its monetary policy is directly tied to that of the U.S. Yet, Hong Kong's 10-year government bond yield is non-trivially below that of the U.S., which argues for a short stance versus similar maturity U.S. Treasurys. While it is true that the Hong Kong - U.S. 10-year yield spread does vary and can widen over a 6-12 month horizon, Chart 11 highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Short Hong Kong REITs / Long Hong Kong Broad Market (Close) There are cross-currents facing the outlook for Hong Kong REITs vs the broad market, arguing for a neutral rather than an underweight stance. Close this trade for an annualized return of 3.6%. While the relative performance of global REITs is typically negatively correlated with bond yields, Chart 12 shows that the relationship with Hong Kong property yields has been positive and lagging (i.e. falling yields lead declining relative performance, and vice versa). Under this regime, a rise in U.S. government bond yields, as we expect, would suggest an improvement in the relative performance of Hong Kong REITs. Chart 11A Straightforward Carry Pick Up Trade Chart 12Rising Bond Yields Implies ##br##Positive HK REIT Performance Chart 13 highlights that periods of positive yield / REIT performance correlation have tended to occur when Hong Kong property prices are rising significantly relative to income, as they have been for the past several years. One interpretation of this dynamic is that when house prices are overvalued and potentially vulnerable, REIT investors react positively to an improvement in economic fundamentals (which tends to push yields up due to higher interest rate expectations). The risk of an eventual collapse of Hong Kong property prices is clear, but we cannot identify an obvious catalyst for this to occur over the coming 6-12 months. Importantly, the fact that property prices have continued to rise during a period of tighter mainland capital controls suggests that only a significant economic shock will be enough to derail the uptrend in prices, circumstances that we do not expect over the coming year. Finally, Chart 14 highlights that Hong Kong REITs are deeply discounted relative to book value when compared against the broad market. This suggests that at least some of the risks associated with the property market have already been priced in by investors. Chart 13Yields & REITs Positively Correlated ##br##When House Prices Are Overvalued Chart 14Hong Kong REITs Are Cheap Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 https://www.bcaresearch.com/trades 2 Please see China Investment Strategy Weekly Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst", dated December 14, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 5 Please note that the total return from this trade had been erroneously reported for some time due a data processing error on BCA's part. The return since inception now properly sources the China CSI SWS Food & Beverage index from CHOICE. We sincerely regret the error and any confusion it may have caused. Cyclical Investment Stance Equity Sector Recommendations