Currencies
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights U.S. bond yields and the U.S. dollar will rise further. Consistently, EM currencies and local bonds will continue selling off. There is meaningful downside in EM exchange rates. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KOR, MYR, IDR, TRY, ZAR, BRL, COP and CLP. Within domestic bond portfolios, overweight low-beta defensive markets as well as Russia and Mexico. Our underweights are Turkey, South Africa, Malaysia and Indonesia. The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy. Feature Emerging market (EM) risk assets will likely continue to be driven by both rising U.S. bond yields and a strong U.S. dollar over the next two months or so. Beyond the next couple of months, the focus of the markets will likely switch to China: renewed weakness in growth and possible instability in its financial markets, with negative implications for China plays globally and for commodities prices in particular. The combination of these two negative forces will lead to a considerable drop in EM currencies in the next six months or so. In turn, EM currency depreciation will trigger broad liquidation of EM risk assets. BCA's Emerging Markets Strategy service believes that EM risk assets will continue to sell off in absolute terms, and underperform their DM/U.S. peers. EM Local Bonds The total return (including carry) index of JPM GBI-EM1 local currency bonds in U.S. dollar terms has rolled over at a critical resistance level (Chart I-1). The total return index of EM local bonds has also relapsed relative to the total return of 5-year U.S. Treasurys, failing to break above its long-term moving average (Chart I-1, bottom panel). Consistently, domestic bond yields have troughed at important technical levels in several key countries such as Brazil, Turkey, Colombia, Russia, South Africa and Malaysia (Chart I-2A and Chart I-2B). Chart I-1EM Local Bonds' Total ##br##Return In US$: Failed Breakout Chart I-2AHave EM Domestic ##br##Bond Yields Bottomed? Chart I-2BHave EM Domestic ##br##Bond Yields Bottomed? In short, EM local bonds are exhibiting negative technical dynamics that corroborate our downbeat fundamental analysis. Consequently, we believe the total return JPM GBI-EM index in U.S. dollar terms will drop to new lows for the following reasons: Currency swings are responsible for most of the fluctuations in EM local bond total returns. As we have elaborated numerous times and re-assert in this report, the outlook for EM exchange rates remains gloomy. Foreign holdings of EM local currency bonds are substantial (Table I-1). Even though there have been improvements in a few countries, current account and fiscal deficits generally remain wide in the majority of developing nations (Chart I-3A and Chart I-3B). In other words, a number of EM economies are still at risk from a slowdown in foreign funding. Table I-1Foreign Holdings Of EM Local Bonds Chart I-3ACurrent Accounts And Fiscal Deficits Chart I-3BCurrent Accounts And Fiscal Deficits Chart I-4U.S. And EM Local Yields Notably, the bar for exchange rate depreciation is very low in EM economies with current account deficits. It takes only a reduction in net capital and financial inflows - i.e., net outflows are not necessary - for these countries' currencies to depreciate significantly. As net foreign funding diminishes, exchange rates of countries with current account deficits should weaken and interest rates should rise in order to compress domestic demand, which in turn would equalize the current account deficit to net inflows in capital and financial accounts. Finally, the spread of EM local bonds (the yield for GBI-EM global diversified index) over duration-matched (5-year) U.S. Treasury yields has not risen much (Chart I-4). Heightened risks in EM currencies warrant higher local bond yield spreads over U.S. Treasurys. Bottom Line: Absolute return investors should stay away from EM local currency bonds. U.S. Bond Yields And The Dollar: More Upside We expect U.S./DM bond yields to keep rising as re-pricing in global fixed income markets continues. The decline in DM bond yields in recent years until the latest selloff was enormous, and some sort of mean reversion should not come as a surprise. Our bias is that this selloff will likely continue until sometime in January, when U.S. President-elect Donald Trump takes office. This riot in the bond market could, in retrospect, resemble a typical "sell the rumor, buy the news" pattern. In other words, by the time President-elect Trump takes office, a lot of bad news will already be priced into the U.S. bond markets, creating a buying opportunity. In our July 13 Weekly Report,2 we argued that: "In the U.S., the combination of a healthy labor market and a heavily overbought fixed-income market have created the backdrop for a material rise in U.S. interest rate expectations/bond yields. As U.S. rate expectations climb, the U.S. dollar should gain support. This in turn will create headwinds for EM currencies and other EM risk assets." Then, we reiterated this view in our July 27 Weekly Report: "Nowadays, there is little talk in the investment community about a bond bubble and the potential for much higher bond yields. Indeed, "lower for longer" has begun to dominate the investor lexicon. This is a sign that many G7 bond bears have likely capitulated. Investor consensus on bonds has become quite bullish, and many investors are long duration. When many bears capitulate, the odds of a market selloff inevitably rise. "Importantly, the increase in G7 bond yields might not be gradual as many expect because of the following: with yields at such low levels, bonds' duration is high and price changes become very sensitive to changes in yield... Such (large) price changes (drops) would amount to large losses for bond investors, and forced selling could intensify. As a result, the unwinding of long positions could be abrupt and volatile." For now, odds are that U.S. bond yields will rise further. Given global bond funds have seen massive inflows in recent years, the latest drop in prices of various bonds has been substantial and will likely trigger withdrawals and redemptions from bond funds, prompting forced selling. This is true for all types of bond portfolios, including DM government and corporates, EM credit (U.S. dollar bonds) and EM local currency bonds. U.S. bond yields are still low, even from the perspective of the past several years, and the market-implied terminal fed funds rate is still 80 basis points below the median projection of the Federal Open Market Committee's longer-run rate (Chart I-5). Given that U.S. interest rate expectations are not high at all, they will rise further (Chart I-6) as the uptrend in U.S. wages persists - driven by an already reasonably tight labor market (Chart I-7). Chart I-5U.S. Interest Rate Expectations Are Still Low Chart I-6U.S. Wage Growth Is Accelerating Chart I-7More Upside In U.S. Treasurys Yields Finally, the U.S. dollar will continue to be buoyed by rising U.S. interest rate expectations. Our composite momentum indicator for the broad trade-weighted U.S. dollar has bounced off the zero line (Chart I-8). This constitutes a strong technical confirmation of the durable bullish market trend in the dollar. Bottom Line: Odds are that the rise in U.S. bond yields is not over. As U.S. bond yields rise further, EM currencies and bonds will sell off. Long-Term EM Currency Trends We have several observations on the long-term performance of EM currencies and financial markets: In the long run, there is no guarantee that the majority of EM currencies will appreciate in real terms (adjusted for inflation differentials). In fact, even countries such as Korea and Taiwan - which have been very successful in their economic development and have tremendously grown their income per capita - have seen their real (inflation-adjusted) exchange rates depreciate over the past several decades (Chart I-9). The case for long-term appreciation in real terms is even weaker for exchange rates in countries that exhibit chronically high inflation rates and/or current account deficits. This has been true for many non-Asian EM currencies (Chart I-10). Chart I-8The U.S. Dollar Is ##br##In A Genuine Bull Market Chart I-9Long-Term Currency ##br##Downtrends In Korea And Taiwan Chart I-10EM Currency Trends: ##br##A Long-Term Perspective Importantly, most losses to foreign investors in EM financial markets often occur via currency depreciation. This is even truer in the current bear market downtrend. The JPM ELMI+ currency total return index (including cost of carry) seems to be about to break down (Chart I-11). In EM ex-China, the real effective exchange rate is still elevated (Chart I-12). Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Chart I-11EM Currency Return With Cost ##br##Of Carry Versus U.S. Dollar Chart I-12Weak Productivity Means ##br##Further Currency Depreciation To limit the upside in domestic interest rates - both in bond yields and interbank rates - many developing nations' central banks will inject more local currency liquidity into their respective systems.3 This might help cap local interest rates, but is bearish for their currencies. The Turkish central bank has been among the most aggressive in this disguised money printing, and not surprisingly the value of its currency has collapsed (Chart I-13). There is no long-term history for EM currencies, as before 1998 most developing nations' exchange rates were pegged. Yet when one examines EM equities' relative performance against the S&P 500, it emerges that there is no single EM bourse that has outperformed U.S. stocks on a consistent basis in the very long run. Chart I-14A and Chart I-14B demonstrate that among 11 EM equity markets that have a long-term history, none have outperformed the S&P 500 over the past 30-35 years. Chart I-13Turkey's Central Bank Has Been ##br##Pumping Local Currency Into The System Chart I-14AEM Equities Versus The S&P 500: ##br##A Long-Term Perspective Chart I-14BEM Equities Versus The S&P 500: ##br##A Long-Term Perspective This goes to reveal that the starting point of underdevelopment and the mark "emerging" does not guarantee consistent outperformance even in the long run. In fact, EM's relative performance against the U.S. has followed multi-year cycles, and we believe the current bear market and underperformance is not yet over. While EM underperformance is long in duration, economic and financial adjustments remain incomplete. DM QE programs and China's still-growing credit bubble have delayed the adjustment. As a rule, the longer a financial or economic imbalance/excess lingers, the more protracted the adjustment will be. Bottom Line: EM exchange rates will continue depreciating. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP. For a complete list of our open currency and fixed-income trades please refer to page 18. Country Allocation For EM Local Bond Portfolios Chart I-15 demonstrates the relationship between developing countries' foreign funding requirements and their real (inflation-adjusted) local bond yields. The foreign funding requirement is calculated as the sum of the current account deficit and foreign debt service obligations over the next 12 months. We use inflation-linked (real) bond yields for markets where they are available. In other cases, we subtract the headline inflation rate from nominal bond yields to derive the real one. Chart I-15Real Bond Yields And Foreign Funding Requirements: A Cross Country Comparison The higher the foreign funding requirement, the higher the real yield must be to attract foreign capital, all else equal. On this diagram, the value pockets are Brazil (its real yield of 6.3% offers the best value by far), Indonesia, Russia and India. Domestic real yields in these countries are relatively high compared to their foreign funding requirements, which is a proxy for exchange rate risk. In contrast, Turkey, Chile, Colombia, Hungary and Malaysia have low real yields relative to their large foreign funding requirements. However, there are other factors that are shaping local yields. For example, Brazilian real yields look very attractive on this matrix because the latter does not account for public debt dynamics. The fiscal dynamics in Brazil are dreadful.4 On the contrary, Chilean local bonds appear expensive, but the country's fiscal outlook is very healthy. After considering all factors that affect local bond yields as well as incorporating the currency outlook, we recommend the following allocations: Overweight Korea, Thailand, Poland, Hungary, the Czech Republic, Russia and Mexico (Chart I-16). For investors who can invest in Chinese, Taiwanese and Indian local bonds, we also recommend overweighting these markets within an EM domestic bond portfolio. Underweight Turkish, South African, Malaysian and Indonesian local currency bonds (Chart I-17). We will publish our analysis on Indonesia soon. Stay neutral on domestic bonds' total return in U.S. dollar terms in Brazil (with a negative bias because of the considerable currency risk), Chile and Colombia (Chart I-18). Chart I-16Our Recommended ##br##Overweights In Local Bonds Chart I-17Our Recommended ##br##Underweights In Local Bonds Chart I-18Local Bonds ##br##Warranting A Neutral Allocation A Word On China's Commodities Frenzy Speculative fever is running high in Chinese commodities exchanges. Frenetic commodities trading in China has seen prices skyrocket of late (Chart I-19). Prices often rise a limit during a day. We have the following observations: This stampede into commodities is a reflection of rotating bubbles in China. Mania forces rotated from property to stocks, then to corporate bonds, and then back to housing, again. It seems to be shifting into commodities now. While the mainland's industrial sector and real demand for commodities have registered gradual improvement in recent months, the sharp spike in commodities prices largely reflects speculative activity much more than real demand. In fact, net imports of base metals have been flat for the past six years (zero growth in six years), and all swings have most likely been related to inventory cycles (Chart I-20). Chart I-19The Spike In Commodities ##br##Prices Trading In China Chart I-20China: Net Import Of Base Metals Like any speculative frenzy, this is momentum-driven and will one day crash. Timing the reversal is impossible. A lot depends on policymakers' willingness to confront this speculative bubble and investor psychology. Notably, onshore corporate bond yields and swap rates have recently begun rising. As in DM bonds, the rise in yields from very low levels is causing large price drops. As and if yields rise further, losses in corporate bonds will become considerable and investors (especially ones managing retail investors' money) will head for the exits, triggering liquidation. This, along with the eventual unraveling of commodities speculation poses substantial potential risk to global, or at least EM, financial markets. Bottom Line: The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy that will end badly. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments. 2 Please see Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016. 3 Please see "EM: Is The Liquidity Upturn Genuine And Sustainable?" Parts I & II, dated November 25, 2015 and December 2, 2015, respectively. 4 Please refer to the Emerging Markets Strategy Special Report, "Brazil: The Honeymoon Is Over," dated August 3, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy The rise in Treasury yields is approaching a threshold that has often caused equity market indigestion. Stay focused on current monetary conditions rather than fiscal unknowns. The bear market in lodging stocks has played itself out: take profits on an underweight position. The sell-off in home improvement retail shares is overdone, and a contrarian long position should pay off despite the backup in mortgage rates. Recent Changes S&P Hotels Index - Take profits of 3% and raise to neutral. Table 1Sector Performance Returns (%) Feature Momentum may carry the market higher in the short run, but from current valuation levels, stocks, the dollar and bond yields can only climb sustainably in tandem if a non-inflationary economic boom is taking hold. In that sense, equities appear to be taking their cue solely from the anticipated U.S. political shift while ignoring the tightening in monetary conditions and hints of emerging market financial strains. The equity market outlook hinges on a judgement call as to whether the action in the currency and Treasury yields is reflective or restrictive? There are no easy answers, but below we discuss some of the variables that influence this decision. Chart 1 shows that the 10-year Treasury yield has climbed above fair value. Equity bulls may rejoice because yields have sauntered much deeper into undervalued territory before stocks have run into trouble. The big difference this time is that the greenback is also climbing. Parallel powerful rises in both the currency and yields are rare, and typically culminate in steep market pullbacks. Importantly, most of the recent yield rise reflects an increase in inflation expectations. The real component, i.e. economic growth expectations, has been far more muted (Chart 2). Chart 1Stocks, Yields, And The Dollar##br## Can't Climb Together For Long Chart 2Inflation Expectations ##br##Are Driving Up Yields Equities shrugged off the surge in yields during the 2013 taper tantrum. However, yields never rose above fair value then, and the increase was almost entirely due to the real component rather than a rise in inflation expectations, i.e. it was more reflective than restrictive (Chart 2). Meanwhile, equities had just been through a difficult stretch in 2012 on fears the euro was going to break apart, and sovereign yields in the periphery were in the early stages of a long descent (Chart 3). In other words, there was a structural tailwind for equities. In addition, the U.S. dollar was range-bound during that period, overall profit growth was strong, business lending was picking up and corporate bond spreads stayed tight (Chart 3). The outlook today is much different. Euro area periphery yields are up sharply, EM bond spreads are flaring out, profit growth is much weaker and the U.S. is importing deflation through U.S. dollar strength (Chart 3), particularly against China and other developing market currencies. Thus, we are uncomfortable making comparisons between today and 2013 broad market resilience. The speed of upward adjustment in Treasury yields also influences equity prices. At the moment, yields are rising faster than profit growth. The overall market has typically become more volatile and often corrects when the growth in yields outpaces profit growth (Chart 4). Chart 3The 2013 Taper Tantrum##br## Is Not A Good Guide Chart 4Too Far,##br## Too Fast? The most painful equity corrections have occurred when this gauge drops below -10%, as the latter suggests that inflation expectations are increasing rapidly, warning of valuation and monetary tightening ahead. This threshold is in danger of being breached on any further rise in yields. However, if the currency continues climbing, yields are unlikely to rise much further, if at all, underscoring that the next big tactical sub-surface market move may be a recovery in yield-dependent sectors as investors begin to fret about the deflationary and profit-sapping impact of a strong dollar. Against this backdrop, we caution against getting too comfortable extrapolating market momentum, because recent gains could be erased just as quickly as they accrued if monetary conditions keep tightening. On a sub-surface basis, value is being created in interest rate-sensitive sectors and destroyed in cyclical sectors, primarily industrials, as discussed last week. Meanwhile, we maintain a domestic vs. global focus, and recommend buying into the pullback in housing stocks. Buy Home Improvement Retailers Like many other interest rate-sensitive groups, home improvement retailers (HIR) have lagged recently, fueled by the surge in bond yields, and hence, mortgage rates. We doubt this is sustainable. U.S. currency strength will refocus attention on the lack of top-line growth in global-oriented industries, which will reverse recent countertrend intra-sector capital flows, and ensure that bond yields are capped. The housing market slowed this year by most metrics (housing starts, permits, sales growth), which undermined remodeling activity. In response, building supply store sales cooled (Chart 5, bottom panel). Recent earnings reports from housing-geared industries such as appliances and furniture vendors have also disappointed. Analysts have been quick to slash both sales and earnings growth estimates (Chart 5). However, as often happens, an overreaction appears to be occurring. There is little indication of a return to punitively deflationary industry conditions. In fact, the producer price index for appliance and furniture makers has shot up in recent months, heralding stronger HIR pricing power (Chart 6, second panel). Lumber prices are also up sharply, despite U.S. dollar strength, which will boost the top-line and profit margins (Chart 6). At a fixed spread over lumber prices, the higher the latter go, the more profit earned at a constant volume sold. We continue to be encouraged by the long-term outlook. Household formation is accelerating now that the unemployment rate is below 5%. Building permits are below average levels, even excluding the housing bubble period (Chart 7). Chart 5Housing Slowdown Already Reflected Chart 6No Sign Of Deflationary Stress Chart 7Still Early In The Mortgage Cycle Consumers have only recently become comfortable taking on mortgage debt, and first time buyers represent a rising share of total home sales. Banks are ready and willing to extend mortgage credit (Chart 7, bottom panel), unlike most other credit. Ergo, housing activity still has legs. While the backup in Treasury yields will no doubt make housing somewhat less affordable, Chart 8 shows that even a 100 basis point rise would not push affordability back to average levels. Mortgage payments would still be well below the long-term average as a share of income, and effective mortgage rates are still extremely low. Therefore, we would not be surprised to see stable housing metrics in the coming months, despite the yield back up. Existing house prices are flirting with new highs (Chart 7), despite the early stage of mortgage re-leveraging, which bodes well for future house price increases. If homeowners are confident that house prices will stay solid, they will be more inclined to make home improvement investments. These factors are represented in our HIR model. The model is climbing steadily, exhibiting a rare positive divergence from relative share prices (Chart 9). Our inclination is to side with the objective message from the model. The valuation case for the group has improved markedly. The forward P/E is well below the average of the last decade and the dividend yield is now on a par with that of the broad market. Typically, a positive yield differential has been a bullish relative performance signal (Chart 10). Chart 8Higher Yields Are Not A Game Changer Chart 9Our Model Remains Firm Chart 10Discounting A Weak Housing Market Most importantly, the industry continues to generate sky-high return on equity, and free cash flow is booming. The implication is that shareholder-friendly stock buybacks and dividend increases should continue apace, especially compared with the overall corporate sector. At current valuation levels, there is room for a playable recovery in relative performance, especially if Treasury yields level off on the back of relentless U.S. dollar strength. Bottom Line: Home improvement retail (BLBG: S5HOMI - HD, LOW) stock price weakness is a buying opportunity. We recommend an above-benchmark allocation. End Of The Bear Market In Hotel Stocks The S&P hotels index has been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. Relative value has been created by the past year of underperformance. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels (Chart 11). Most notably, the relative price/sales ratio is almost on a par with the lows during the Great Recession, when a steep contraction was anticipated for the foreseeable future. Such a dire forecast is not in the cards, even if economic growth disappoints an increasingly optimistic consensus. The plunge in net earnings revisions has not been confirmed by a downturn in hours worked. Typically, these two series move hand-in-hand (Chart 12). Instead, hours worked continue to trend higher suggesting that reduced profit guidance is bringing analyst expectations to more attainable levels rather than signaling impending doom. After all, persistent hotel construction growth means that demand needs to run hot in order to keep deflationary pressures at bay. This has been a tall order in the past year, as tight business budgets and lackluster discretionary consumer spending have kept REVPAR under wraps (Chart 13). Occupancy rates remain below previous expansionary run rates, leaving revenue per room more exposed than normal to demand soft spots. Chart 11End Of Bear Market Chart 12An Undershoot In Estimates Chart 13Slow, But Steady, Growth REVPAR could be supported by decent consumer spending. Wage growth, and thus aggregate income, are perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power (Chart 13). Importantly, hotel profit margins are no longer under extreme duress. Decent pricing power gains and an easing in the industry's total wage bill inflation have combined to support an increase in our profit margin proxy (Chart 14). All of this implies that profit conditions are stabilizing, just as valuations have been squeezed, warranting an upgrade to neutral. Why not a full shift to overweight? There are a number of factors to consider. The lodging industry is battling secular crosscurrents. On the positive side, the lodging industry has consistently managed to increase its share of total consumer spending, in real terms (Chart 15), with periodic underperformance phases, typically during recessions. This likely reflects well-timed capacity investments and strong brands. As a result, hotel pricing power has also been in a structural uptrend (Chart 15). This cycle, pricing power has lagged, consistent with subdued REVPAR gains, but hotels have still managed to aggressively grow earnings per share. While buybacks have undoubtedly played a role in this advance, EPS is following a typical pattern. In the last four decades, hotels have suffered four major recession-related earnings contractions. After each contraction, profits ultimately surpassed their previous peak by more than 75%, on average. The duration of the upcycle averaged five years. This cycle the recovery has already lasted more than six years, but hotel profits have only increased 30% from the 2007 peak. That implies substantial profit upside ahead just to reach the average, albeit pricing power will need to kick in as it has in past cycles. On the downside, consumers are still showing a penchant for spending more on essentials compared with non-essentials. The ratio of retail sales at cyclical stores to non-discretionary stores has been highly correlated with relative performance (Chart 16, top panel). Chart 14The Margin Squeeze Is Over Chart 15Structural Tailwinds... Chart 16... And Headwinds That raises some question about the latest burst of strength in lodging outlays, especially in view of the pruning in business travel budgets, as confirmed by anecdotes from recent earnings reports. BCA's capital spending model is not forecasting any improvement (Chart 16, bottom panel). Lingering in the background has been the relentless increase in lodging construction. Capacity growth represents a long-term threat to pricing power (Chart 16), over and above the threat from new entrants such as AirBnB. Expansion explains why real hotel consumer prices have not come close to hitting new highs even though real hotel spending has. Hotel capacity expansion heralds intensifying deflationary pressure. Meanwhile, hotels have sizeable global operations, exposing profitability to risks of incremental U.S. dollar strength. Consequently, we would prefer to await signs of an impending improvement in capital spending, and thus, business travel, and/or a sharp downturn in hotel construction spending, before lifting positions all the way to overweight. Bottom Line: Lift the S&P hotels index (BLBG: S5HOTL - MAR, CCL, RCL, WYN) to neutral, locking in an 3% relative performance profit since our initial underweight call nearly a year ago. A further upgrade is tempting, but awaits relief from pricing power constraints. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally Chart I-42005: Commodity##br## Rally Was An Oil Rally Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Chart I-6China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds Chart I-8DM Hurting EM EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth Chart I-10The Liquidity ##br##Channel Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. Chart I-15Favorable Supply/Demand Backdrop For Oil Chart I-16A Good Entry Point For Shorting AUD/CAD Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight Chart I-18A Countertrend Move In USD/JPY Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In November, the model underperformed global equities and the S&P in USD and in local-currency terms. For December, the model reduced its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). Within the equity portfolio, most of the decrease in allocation came at the expense of EM, Sweden, Netherlands, U.S., and New Zealand. The model increased its weighting in Swedish, French, U.K., and Canadian bonds. The risk index for stocks deteriorated in November, while the bond risk index improved significantly. Chart 1Model Weights Feature Performance In November, the recommended balanced portfolio lost 1.5% in local-currency terms and was down 3.4% in U.S. dollar terms (Chart 2). This compares with a gain of 1.3% for the global equity benchmark, and a 3.7% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The sharp bond selloff and weakness in EM equity markets both took a toll on the model's performance in November. Weights The model cut its allocation to stocks from 66% to 53%, and increased its bond weighting from 26% to 47%. The allocation to cash was brought down to zero from 8%, while commodities remain excluded from the portfolio (Table 1). The model trimmed its allocation to Latin American equities by 4 points, Sweden by 3 points, and the Netherlands by 3 points. Also, weightings were reduced in U.S., New Zealand, Spanish, and Emerging Asian stocks. In the fixed-income space, the allocation to Swedish paper was boosted by 12 points, France by 7 points, Canada by 5 points, the U.K. by 3 points, and Italy by 1 point. Allocation to New Zealand bonds was decreased by 6 points and U.S. Treasurys by 1 point. Chart 2Portfolio Total Returns Table 1Model Weights (As Of November 24, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated significantly in November following the U.S. presidential election. Our Dollar Capitulation Index spiked and is currently at levels that suggest the rally in the broad trade-weighted dollar could pause (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The momentum indicator for commodities has moved further into overbought territory, pushing up the overall risk index. This asset class remains excluded from the portfolio (Chart 4). The deterioration in the liquidity and momentum indicators has lifted the risk index for global equities to the highest level in over 2 years. Our model cut its weighting in equities for the fourth month in a row (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The risk index for U.S. stocks increased sharply in November. With stocks reaching new highs, the model trimmed its allocation to this bourse. The markets took note of the growth-positive aspects of Trump's policies, but seem complacent about the stronger dollar, higher interest rates, and the potential for trade protectionist policies (Chart 6). The risk index for euro area equities has ticked up slightly in November. However, unlike its U.S. peers, it remains in the low-risk zone. Above-trend growth could provide support for euro area equities. (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk The risk index for Dutch equities ticked up slightly and the model has downgraded this asset. That said, the weighting in Dutch equities remains the highest among its euro area counterparts (Chart 8). Improvements in the value and momentum measures for Latin American stocks have been largely offset by a deteriorating liquidity reading. As a result, the risk index did not decline much after the selloff. The model decreased its allocation to this asset (Chart 9). Chart 8Dutch Stock Market And Risk Chart 9Latin American Stock Market And Risk Over the course of only a few months, the risk index for bonds has swung from an extremely high risk level to the low-risk zone. Momentum has been the primary driving force behind this move and currently suggests that yields could pull back in the near term (Chart 10). The risk index for U.S. Treasurys declined significantly in November. While the model used the latest selloff to boost its allocation to bonds, it preferred to add allocation to bond markets outside of Treasurys. (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk After the rise in yields, Canadian bonds are massively oversold based on our momentum measure. The extremely low-risk reading has prompted the model to allocate to this asset (Chart 12). German bonds are oversold, but the reading on the cyclical measure has become considerably more bund-unfriendly. The model opted not to include bunds in the overall boost to its bond allocation. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13German Bond Yields And Risk The risk reading in French bonds is more favorable than for bunds. Apart from oversold momentum, the value reading has also improved. The model increased its allocation to French bonds (Chart 14). The cyclical component of the risk index for Swedish bonds keeps moving in a bond-bearish direction. But that is completely overshadowed by extremely oversold conditions. In fact, the overall risk index for Swedish bonds is the lowest within our bond universe. Much of the increase in overall bond allocation ended up in Swedish paper (Chart 15). Chart 14French Bond Yields And Risk Chart 15Swedish Bond Yields And Risk Following sharp gains, the 13-week momentum measure for the U.S. dollar has reached levels at which some consolidation may take place. But the recovery in the 40-week rate of change measure indicates that it would probably be a pause in the dollar bull market rather than a trend change. With the December rate hike baked in, the Fed's communication about the policy next year holds the key to the path of the dollar - in addition to the fiscal policy of the next administration (Chart 16). The Japanese yen has been a major victim of the dollar rally. The 13-week momentum measure is approaching levels that halted the yen weakening trend in 2013 and 2015. However, this time around, it is not coupled with the same signal from the 40-week rate of change measure. The BoJ is sticking to its easy monetary policy, and some additional support on the fiscal front could drag the yen lower, notwithstanding a possible hiatus in the short term. Short term the yen could benefit from an EM pullback (Chart 17). After the latest bout of depreciation, the euro seems poised for another attempt to break below 1.05. The 13-week and 40-week momentum measures do not preclude this from happening. However, it would probably take the ECB to reaffirm its dovish message to push EUR/USD technical indicators into more oversold territory (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession Chart 8Protectionist Measures ##br##Are On The Rise Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? Stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? Overweight the Eurostoxx600 versus the Nikkei 225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Underweight the Eurostoxx600 versus the S&P500. Feature 2016 is the year of the political shock. But for investors, some things have stayed faithfully the same. Chart of the WeekEurostoxx Vs. Nikkei Reduces To: Will Euro/Yen Weaken? Last week's report From Berlin Wall To Mexican Wall explained how the fall of the Berlin Wall in 1989 ushered in a great era of globalization - an era in which goods, services, capital and people have moved around the world more and more freely. Chart I-2The Globalization Of Stock Markets For investors, one major upshot is that the world's biggest companies have also become more and more globalized. The leading European stock market indexes - Eurostoxx600, FTSE100, DAX30, CAC40 and many other national indexes - are now just a collection of multinational companies with a global footprint. The same applies to major indexes outside Europe, such as the Nikkei225 and S&P500. Before the era of globalization, many companies had little exposure to economies outside their country or region of domicile. Unsurprisingly, in the 1980s, a German bank share price was more correlated with the rest of the German stock market than it was with a U.S. bank share price. But today, a large proportion of sales and profits are sourced globally. The German bank share price is now more correlated with the U.S. bank share price than it is with the rest of the German stock market! (Chart I-2) This begs the question: if Brexit and President-elect Trump are ushering in a great era of anti-globalization, will the major indexes become parochial once again? The answer is perhaps, but it will be a slow process - even assuming that the anti-globalization rhetoric does fully materialize. Sometimes, Stock Market Allocation Reduces To A Currency View For the time being, one obvious distinction between the major indexes will remain instrumental in driving performance differences. The Eurostoxx600 is denominated in euros, the FTSE100 in pounds, the Nikkei225 in yen, and the S&P500 in dollars. However, the constituent companies' sales and profits are denominated in a mixture of major global currencies, or in dollars. So all else being equal, if the local currency weakens - in other words, if other global currencies strengthen versus the local currency - then index profits will rise in local currency terms. Meaning the index value must go up. And if the local currency strengthens, the index value must go down. Simplistic as it sounds, some important asset allocation decisions just reduce to a bi-lateral currency view. Chart I-3 clearly shows that Eurostoxx600 versus FTSE100 relative performance reduces to a simple question: will the euro weaken against the pound? If so, the Eurostoxx600 will outperform the FTSE100. And vice-versa. Clearly, the outlook for euro/pound has been an important question this year, and will be an equally important question next year. Chart I-3Eurostoxx Vs. FTSE Reduces To: Will Euro/Pound Weaken? Likewise, the Chart of the Week clearly shows that Eurostoxx600 versus Nikkei225 relative performance reduces to a similar simple question: will the euro weaken against the yen? If so, the Eurostoxx600 will outperform the Nikkei225. And vice-versa. Sometimes, Stock Market Allocation Reduces To A Sector View But in the case of the Eurostoxx600 versus the S&P500, relative performance does not reduce to the direction of euro/dollar. Since mid-2014, the euro has weakened substantially versus the dollar, yet the Eurostoxx600 has underperformed the S&P500. This is because another factor drives this relative performance pair (Chart I-4 and Chart I-5). Chart I-4Eurostoxx Vs. S&P500 Does Not ##br##Depend On Euro/Dollar... Chart I-5...Eurostoxx Vs. S&P500 Does Depend ##br##On Banks Vs. Technology Although major indexes are a collection of multinational companies, it doesn't follow that the sector exposures of these indexes will be the same. Comparing the Eurostoxx600 with the S&P500, the Eurostoxx600 has a marked overexposure to Banks and an especially marked underexposure to Technology (Table I-1). Table I-1Eurostoxx Vs. S&P500 = Overweight##br## Banks, Underweight Technology Banks comprise 13% of the Eurostoxx600 market capitalization but only 6% of the S&P500. On the flipside, Technology comprises just 4% of the Eurostoxx600 market capitalization but a very substantial 21% of the S&P500. To repeat, multinational company share prices today are more correlated with their global sector than with their domestic stock market of listing. Recently, this has been true even for U.S. Banks - which amazingly have shown a higher correlation with European Banks than with the rest of the U.S. stock market. It follows that when two indexes are distinguished by large sector skews, these sector skews will drive relative performance. Our Special Reports Picking Countries The Right Way 1 Parts 1, 2 and 3 showed that this is the case for most head to head stock market comparisons within Europe. It is also the case for the Eurostoxx600 versus the S&P500. Put simply, for the Eurostoxx600 to outperform the S&P500 on a sustained basis, Banks must outperform Technology on a sustained basis. Or to be more precise, European Banks must outperform U.S. Technology (Chart I-6). Chart I-6Eurostoxx Vs. S&P500 Reduces To: Will European Banks Outperform U.S. Technology? Applying Reductionism To The Eurostoxx600 We can now apply investment reductionism to position the Eurostoxx600 against three other major indexes: the FTSE100, the Nikkei225 and the S&P500. 1. Eurostoxx600 outperformance versus the FTSE100 reduces to: will the euro weaken against the pound? For the foreseeable future, the euro/pound exchange rate hinges on the perceived severity of Brexit. In this regard, there is unlikely to be meaningful new information until the U.K. Supreme Court delivers its verdict on the legal process that the U.K. government must follow. The verdict is due in January. So for the time being, it is appropriate to stay neutral in the Eurostoxx600 versus the FTSE100. Eurostoxx600 outperformance versus the Nikkei225 reduces to: will the euro weaken against the yen? 2. The euro/yen exchange rate hinges on ECB/BoJ relative monetary policy. Given that the BoJ made its bold policy move a few months ago, the focus now is on whether the ECB will continue with QE beyond March 2017. Chart I-7European Banks Do Not Offer An Especially##br## Large Discount To U.S. Technology The minutes of the ECB's most recent policy meeting provide some clues. On the one hand, the central bank cautioned on the unintended consequences of extended QE: "The possible side effects of the low interest rate environment and the range of non-standard measures in place on the longer-term intermediation capacity of banks and other financial institutions had to be further examined" On the other hand, the ECB emphasised: "(QE) was set to run... in any case until the ECB saw a sustained adjustment in the path of inflation consistent with its inflation aim... underlying inflation, however, continued to lack clear signs of a convincing upward trend." On this basis, it seems that the ECB will extend its QE program beyond March 2017, as well as give a strong commitment to keep policy rates anchored. But the recent underperformance of the Eurostoxx600 versus Nikkei225 has discounted a sizable strengthening of euro/yen. It is appropriate to lean against this and overweight the Eurostoxx600 versus the Nikkei225. Eurostoxx600 outperformance versus the S&P500 reduces to: will European Banks outperform U.S. Technology? Again, the minutes of the ECB's most recent policy meeting perfectly summarized the environment for European banks: "Ongoing structural challenges to banks' balance sheets, notably arising from still high levels of non-performing loans (NPLs) in parts of the euro area banking sector, in conjunction with regulatory challenges (BRRD), and the weakness in profitability were seen to pose a risk to the transmission of monetary policy and a further recovery in credit dynamics" Or as we recently put it,2 European bank investors are fighting three long-term headwinds: BRRD, NPLs and NIRP. Yet on a price to forward earnings multiple, European Banks do not offer an especially large discount to U.S. Technology (Chart I-7). Therefore, investment reductionism says it is appropriate to underweight the Eurostoxx600 versus the S&P500. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Please see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015, available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report "All Roads Lead To Banks", dated October 6, 2016, available at eis.bcaresearch.com Fractal Trading Model* The recent sharp moves in markets offer another opportunity for a long plantinum / short palladium pair-trade. A similar opportunity on October 6 successfully signaled a 13% countertrend move. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong Chart I-2BMedium Expansions Chart I-2CA Short Expansion Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Chart III-5BJapanese Vs. U.S. Fundamentals... Chart III-6RoE Is Consistently Lower In Japan Table III-1Japanese Vs. U.S. Sector Weights The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) Chart III-7BMechanical Valuation Indicators (I) Chart III-7CMechanical Valuation Indicators (I) Chart III-7DMechanical Valuation Indicators (I) Chart III-8AMechanical Valuation Indicators (II) Chart III-8BMechanical Valuation Indicators (II) Chart III-8CMechanical Valuation Indicators (II) The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.