Developed Countries
Dear Client, In addition to this week's regular Weekly Report, you should have also received a Client Note written by my colleague Marko Papic discussing the upcoming U.S. presidential election. Marko argues that the election is now too close to call. Donald Trump's resilience in the polls continues to baffle most observers. Not us. Back in September of 2015, when most pundits were laughing off Trump's chances, we wrote a report arguing that Trump's rhetoric would resonate with voters much more than most people thought possible. That report, entitled "Trumponomics: What Investors Need To Know," is as relevant today as it was back then. Best regards, Peter Berezin Highlights Spare capacity has narrowed substantially within the developed world. Most of the decline in spare capacity is attributable to lackluster supply, rather than stronger demand. Potential GDP growth is likely to remain weak over the coming years. Narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. At least in this respect, central bankers may find themselves with a few more bullets in their arsenals. Stay long the dollar and position for gradually higher government bond yields. Global equities are highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. Feature Spare Capacity Is Dwindling A persistent shortfall of aggregate demand has been the defining feature of the global economic landscape ever since the financial crisis erupted. This chronic lack of spending has kept inflation below target in most developed economies, forcing central banks to adopt ever more radical easing policies. That is starting to change. Spare capacity continues to decline, allowing once dormant supply-side constraints to reimpose themselves. In this week's report, we take stock of where we are in this process. Mind The (Output) Gap The simplest measure of spare capacity is the so-called output gap, which estimates the difference between what economies are actually producing and what they are capable of producing without putting undue upward pressure on inflation. According to the IMF, the output gap for advanced economies has narrowed from a high of 3.8% of GDP in 2009 to 0.8% at present. The OECD's measure shows a similar decline (Chart 1). Chart 1AOutput Gaps Have Narrowed Chart 1BOutput Gaps Have Narrowed The IMF reckons that the output gap has nearly closed in the U.S. and the U.K. The Fund estimates that Japan's output gap currently stands at 1.5% of GDP. The OECD also sees the U.K. output gap as being fully closed. However, it calculates a smaller output gap for Japan but a larger output gap for the U.S. than the IMF does. Both institutions peg the euro area's output gap at around 1%-to- 1.5%. Not surprisingly, there is a fair bit of variation within continental Europe. The output gap in Germany has fully disappeared, but still stands at 2%-to-3% of GDP in Italy and Spain. Naturally, one should take these numbers with a grain of salt. Output gaps are notoriously difficult to calculate and are subject to large revisions. The OECD, for example, tends to rely on statistical approaches to estimate output gaps.1 These typically involve employing tools such as the so-called "Hodrick-Prescott filter" to smooth out historical GDP data and then treating the resulting trendline as an estimate for potential GDP. Such methods have their uses, but they can go badly awry in situations where GDP is slow to return to its "true" underlying trend. This is a particular worry in the current environment, considering that recoveries following burst asset bubbles tend to be lethargic even in the best of times. The fact that fiscal policy has been fairly tight and monetary policy has been constrained by the zero lower bound has further dampened the recovery. With that in mind, rather than relying on purely statistical techniques, it is useful to measure spare capacity directly. We do this by gauging the extent to which the existing factors of production - labor and capital - are being effectively deployed across the major developed economies. As we argue below, this approach suggests that slack may be modestly higher in Japan than what the IMF and the OECD calculate, and more meaningfully understated in peripheral Europe. The Message From Headline Unemployment Rates Unemployment has been falling in almost all major developed economies (Chart 2). In the U.S. and the U.K., the jobless rate is back to pre-crisis levels. In Germany and Japan, it is below where it was before the Great Recession. As such, it is unlikely that unemployment can decline much in these economies. Chart 2AUnemployment Rates Have Declined Chart 2BUnemployment Rates Have Declined In contrast, while unemployment rates in peripheral Europe have been trending lower over the past three years, they are still quite high by historical standards. There is some debate over whether they can fall much further. The OECD, for example, contends that Spain is already close to full employment, even though the country's unemployment rate still stands at nearly 20%. We find this implausible. The OECD essentially takes a moving average to calculate structural unemployment rates in various economies. As noted above, this can be highly misleading in circumstances where the forces pushing an economy towards full employment are impaired. In general, this suggests that both the IMF and the OECD estimates of labor market slack in the euro area are too low. This is consistent with a recent ECB research paper, which calculated that the euro area's output gap was 6% of GDP in 2015, a far cry from the European Commission's estimate of 1.1%.2 Disguised Unemployment The unemployment rate is probably the single best measure of labor market slack. However, it can understate the true amount of spare capacity during periods when many people have stopped looking for work, or when those who are employed are not working as much or as intensively as they would like. The nature of this additional labor market slack differs from region to region. In the U.S., it has mainly manifested itself in lower labor force participation rates; whereas in Europe - perhaps in keeping with the more egalitarian nature of European society - it has mainly taken the form of fewer hours worked and a higher incidence of involuntary part-time employment. Chart 3 shows that labor force participation rates among prime-age workers (those between the ages of 25-and-54) in Europe are generally higher now than they were before the financial crisis. In contrast, the share of workers who have part-time jobs but desire full-time employment remains elevated across most of continental Europe (Chart 4). The average annual number of hours worked per employee has also declined in most European economies (Chart 5). Chart 3ALabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 3BLabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 4AEurope: Higher Incidence Of ##br##Involuntary Part-Time Employment Chart 4BEurope: Higher Incidence ##br##Of Involuntary Part-Time Employment In the U.S., the prime-age labor force participation rate is still 1.9 points lower than it was in 2007. Part of this is cyclical. As long as the labor market continues to improve, participation rates among prime-age workers should continue to recover. That's the good news. The bad news is that ongoing structural forces are likely to prevent the participation rate from returning back to its pre-crisis levels. Chart 6 shows that labor force participation rates among U.S. prime-aged males has been trending lower since the 1960s. The decline has been particularly acute among less-educated workers. Why this has happened remains a source of intense debate. Conservative commentators have argued that cultural shifts have reduced the social pressure on men to maintain gainful employment. Liberal commentators have contended that falling real wages at the lower end of the skill distribution have reduced the incentive to work. Whatever the reason, it will be difficult to boost labor participation substantially from current levels. At present, 11% of U.S. prime-aged nonparticipants report wanting a job, only modestly higher than before the recession (Chart 7). It is possible that some fraction of those who do not want to work will change their minds - indeed, this year has seen a modest inflow of "disabled" people back into the labor force. Realistically, however, this is unlikely to boost labor participation by more than one percentage point. Chart 5Hours Worked ##br##In Europe Have Declined Chart 6U.S.: The Less Educated ##br##Are Shunning The Labor Force Chart 7U.S.: Fewer Potential Workers ##br##On The Sidelines Chart 8Japan's Underutilized Labor Force The incidence of involuntary part-time employment in Japan has returned to where it was prior to the Great Recession. However, in absolute terms, it remains quite high - in fact, nearly as high as in Europe. Japanese full-time employees may also not be as productively engaged as they could be. As evidence, note that output-per-hour in Japan is 37% lower than in the U.S. and 33% lower than in Germany (Chart 8). From this we conclude that there is somewhat more labor market slack in Japan than the headline unemployment rate suggests. Industrial Capacity Utilization Goods-producing sectors typically account for less than a third of GDP in most advanced economies. Nevertheless, because the demand for goods tends to be more volatile than the demand for services, fluctuations in industrial production often account for the bulk of the changes in output gaps. As Chart 9 shows, after a brisk recovery following the financial crisis, the U.S. industrial capacity utilization rate has been trending lower for the past two years. It currently stands at 75.4%, 5.6 percentage points lower than at its pre-recession peak. The Institute for Supply Management's semi-annual capacity utilization survey also suggests that many U.S. manufacturing businesses are operating substantially below potential (Chart 10). Much of the deterioration in U.S. industrial utilization reflects the effects of the energy bust and a stronger dollar. Business capex has decelerated sharply as a consequence of these forces, falling by over two-thirds in the case of energy capex. This should cut into excess capacity. Chart 9U.S.: Industrial Capacity ##br##Utilization Remains Low Chart 10U.S.: Less Slack In Services ##br##Than Manufacturing The dearth of new investment elsewhere in the world should also help prop up utilization rates (Chart 11). Industrial utilization is close to its historic average in Europe. Unlike in the case of labor markets, there is not a lot of regional variation in capacity utilization rates across the euro area. If anything, Italian spare capacity is actually closer to its pre-recession level than Germany's. Chart 11AEurope: Idle Industrial Capacity Is Shrinking Chart 11BEurope: Idle Industrial Capacity Is Shrinking Chart 12Excess Capacity Has Declined In Japan Capacity utilization has also returned to its long-term trend in Japan. Encouragingly, the Tankan Factor Utilization Index has risen to its highest level since the early 1990s (Chart 12). Nevertheless, the strong yen is starting to put pressure on Japan's industrial sector. This suggests that further monetary easing from the BoJ will be necessary. Economic And Investment Implications Our analysis suggests that spare capacity has narrowed substantially within the developed world, although for some countries not quite as much as output gap estimates from the IMF and the OECD indicate (particularly in the case of peripheral Europe). Unfortunately, most of the decline in spare capacity is attributable to lackluster supply, rather than faster demand growth (Chart 13). Interestingly, a cyclically-induced withdrawal of workers from the labor market has only played a modest role in explaining the slowdown in potential GDP growth and the resulting decline in output gaps. Instead, most of the deceleration in potential GDP growth stems from lower productivity gains. Chart 13AWeak Supply Growth Has Narrowed Output Gaps Chart 13BWeak Supply Growth Has Narrowed Output Gaps Some of the decline in productivity growth reflects cyclical factors, especially weak business investment. However, as we have discussed in past reports, much of it reflects structural forces such as declining educational achievement and a shift in focus of internet innovation away from business productivity applications towards consumer services such as social media.3 Looking out, narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection via the CPI swap market. Governor Kuroda has made it clear that he wants Japanese inflation to rise above 2% to make up for the fact that inflation has perpetually undershot the BoJ's target. The Bundesbank may not want higher inflation, but the ECB's need to reflate Southern Europe all but guarantees such an outcome. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. The essence of forward guidance is the commitment to keeping monetary policy ultra loose even when the economy begins to overheat. If people believe that the central bank will keep the punch bowl filled, this could cause long-term inflation expectations to rise, leading to lower real yields and increased spending today. Such a commitment is likely to be regarded as more credible if people expect it to be carried out over the next few years, rather than at some distant point in the future. The Bank of Japan has already moved in that direction with its pledge to engineer an inflation overshoot by keeping the 10-year JGB yield anchored at zero. Chart 14China: On The Mend, Cyclically The U.S. has the smallest output gap, but the highest neutral interest rate, among the major developed economies. This week's FOMC statement strongly hinted at a December rate hike. As we discussed two weeks ago, in addition to one hike this year, we expect the FOMC to hike rates twice next year.4 This should cause the real broad trade-weighted dollar to appreciate by 10% over the next 12 months. A stronger dollar will mitigate some of the upward pressure on U.S. bond yields. Nevertheless, as slack continues to erode and inflation shifts higher, Treasury yields, along with bond yields elsewhere, should continue trending higher. Global equities are currently highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. We are currently short the NASDAQ 100 futures as a hedge, a trade that has gained 3.1% since we initiated it. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. This is partly because U.S. stocks are relatively expensive, but it is also because an ascending dollar will hurt U.S. multinationals. Investors should overweight Japanese and European stocks on a currency-hedged basis within the developed market universe. The outlook for emerging markets is mixed. On the one hand, the recent uptick in Chinese growth - as evidenced by this week's better-than-expected PMI data (Chart 14) - should provide some support to commodity prices and EM assets. On the other hand, a stronger dollar will weigh on commodities, while making it more onerous for some emerging market companies to refinance their dollar-denominated loans. Higher U.S. rates could also reduce the global pool of dollar liquidity, making it difficult for some emerging markets to finance their current account deficits. On balance, a modestly underweight stance towards EM assets is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 The IMF uses a more ad hoc approach. Desk economists have significant leeway in how they estimate output gaps for their respective economies. Most economists rely on statistical models and production function calculations, intermixed with educated guesswork. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015; and Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades
The relative performance of media stocks over the past few months would seem to foretell of a downturn in cash flow prospects. However, the opposite is true. The latest consumer spending data showed that outlays on media products and services are accelerating, both in absolute terms and relative to total consumption. In turn, that is driving up media pricing power, to growth rates not seen in more than a decade. Media pricing power often leads relative sales growth expectations, pointing to a re-rating ahead. Importantly, media productivity is also on the upswing, as proxied by sales-to-employment, which leads momentum in relative forward profit estimates. The implication is that the budding recovery in the share price ratio is likely to gain traction. Stay overweight.
Financial stocks have risen in sympathy with the back up in global bond yields, but that likely represents position squaring more so than a sustained shift into the sector. Financial profits will continue to be challenged by a downturn in the credit cycle, both in terms of quality and loan creation, given the negative global credit impulse and flattening yield curve (shown inverted and advanced, bottom panel). Importantly, productivity is waning. Financial sector employment is probing new highs, reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales (third panel), a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. We continue to view cheap financial sector valuations as a trap, and recommend below benchmark positions.
A reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent, underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions, suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: the pain in drug-related shares should provide a gain to health care insurers. Stay overweight.
A number of drug wholesalers have reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic drug pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has neither been confirmed by still strong retail drug store sales nor booming hospital employment. Nevertheless, in light of new information, which implies that company disclosed pricing pressure is worse than current government data show, we are downgrading our outlook for drug-related shares. However, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels, we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. In the meantime, the S&P pharma and biotech indexes are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit, see the next Insight.
Highlights U.S. Corporates: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay defensive in Euro Area corporates, favoring Investment Grade over High-Yield. Feature Better Global Growth Not Necessarily Better For Corporate Bonds Back in July of this year, BCA put its flag in the ground and called an end to the 35-year global bond bull market after government bond yields hit historic lows following the shocking U.K. Brexit vote.1 Yields have steadily crept up since we made that declaration, due to a combination of changing cyclical factors (improving global growth, modest increases in inflation), some signs of diminished political concerns (no immediate global spillovers from a more drawn-out Brexit process, the fall in the odds of victory of the "anti-status-quo" candidate in the U.S. presidential election, Donald Trump) and structural factors (worries about less accommodative monetary policies, a political shift towards greater deficit-financed government spending). While government bond yields have been rising from depressed levels, corporate bond returns on either side of the Atlantic Ocean have at the same time lost considerable momentum, both in absolute terms and relative to sovereign debt (Chart of the Week). This is a bit of a surprise given the recent improvement in global growth data that is now appearing in a broadening number of countries (Chart 2), which would suggest a potential brighter outlook for corporate earnings. However, credit valuations and the liquidity backdrop matter, and a potential cyclical improvement in profits may not benefit corporate bond performance at a time of tight spreads and greater uncertainty about future central bank policies. Chart of the WeekIs The Party Ending For Corporate Bonds? Chart 2A Broadening Pickup In Global Growth With credit spreads currently priced for a near-perfect backdrop of low volatility and highly accommodative central banks, we continue to recommend an overall defensive posture in "Trans-Atlantic" corporate bonds, favoring Investment Grade (IG) over High-Yield (HY) in both the U.S. and Euro Area. Chart 3U.S. Corps Are Now ONLY A 'Tina' Trade U.S. Corporates: Stretched Valuations, Especially For Junk Bonds U.S. corporate bonds have been one of the biggest beneficiaries of the so-called "TINA" (There Is No Alternative) trade, where investors have been forced into riskier assets out of low-yielding government bonds. The return performance for both investment grade (IG) and high-yield (HY) debt has been outstanding, with the former up 8.2% year-to-date and the latter up +15.9%. The fundamental backdrop for corporate debt, however, has shown few signs of any improvement that would justify such strong returns, according to our U.S. Corporate Bond Checklist (Chart 3): 1.Corporate balance sheets are deteriorating: Our U.S. Corporate Health Monitor (CHM), an amalgamation of various bottom-up credit metrics applied to top-down corporate profit data, continues to signal that balance sheets are worsening. This trend has been ongoing for more than two years and shows no signs of slowing, with companies continuing to ramp up leverage to record highs at a time of increasing downward pressure on profit margins. 2.Bank lending standards are slowly tightening: The U.S. Federal Reserve's Senior Bank Loan Officer Survey has begun to flash that a greater number of U.S. banks are tightening lending standards on commercial & industrial loans. The net number is still low within the history of this series, and is largely the result of tightening standards on domestic energy companies suffering from the lower oil prices of the past two years. Nonetheless, the highly cyclical nature of lending standards suggests that a move back to easier standards may not happen at this advanced stage of the multi-year credit cycle. 3.Monetary conditions are tighter, but remain stimulative: Our U.S. Monetary Conditions Index (MCI), which is a weighted combination of short-term interest rates and the U.S. dollar, remains at an accommodative level, even after the 18% rise in the trade-weighted dollar since the trough in 2014 and the Fed's lone rate hike last year.2 Interest rates are far more important in our MCI calculation than the dollar (by a 10/1 ratio), however, so it would take an exceptionally large move in the dollar to push the MCI to restrictive territory after just a single 25bp rate hike. Yet with the Fed clearly in a slow hiking cycle that could deliver at least another 75bps of rate hikes by the end of 2017, the MCI will continue in a tightening direction that has historically been correlated with wider corporate bond spreads. With only an easy money backdrop supportive of narrower credit spreads, there is a growing risk that U.S. corporates could respond poorly to a December Fed rate hike that we expect - especially if that also coincides with renewed strength in the U.S. dollar. Already, the Fed's trade-weighted dollar index has risen by 3.2% during the recent Treasury market selloff, as the market-determined probability of a December hike has risen to 66%. This remains below the peaks seen in the run-up to the rate hike at the end of 2015, which coincided with a big widening of corporate credit spreads (Chart 4). One major difference from a year ago is that the Fed is not signaling the same degree of monetary tightening after the next hike. The FOMC median interest rate projections (the "dots") were indicating another 100bps of hikes following the December 2015 rate increase, and are now only signaling another 50bps of hikes after the Fed's expected next move in December. This is keeping both the 2-year Treasury yield and the dollar well below the peaks seen at the end of last year, helping prevent a breakout in market volatility and credit spreads. So if there is a fresh spike in volatility and/or the dollar, it would be striking the corporate credit markets at a time when valuations look stretched. We can see that in a number of indicators. U.S. corporate bond excess returns have far exceeded the levels suggested by domestic capacity utilization, which are relevant for corporates given their long-standing correlation to profit margins (Chart 5). Our colleagues at our sister publication, U.S. Bond Strategy, have calculated that a 0.4% improvement in capacity utilization has historically coincided with a 100bps tightening in HY bond spreads over a 1-year period; thus, utilization would have to rise to 77.2% by next February (a level last seen in March 2015 when the annual growth rate of Industrial Production was 2.5 percentage points faster than the current pace) to justify HY spreads at current levels.3 In other words, junk bonds are already priced for a significant recovery in U.S. economic growth and corporate profits. Chart 4U.S. Corps Not Responding To A Rising USD...Yet Chart 5Ignoring The Signal From Capacity Utilization U.S. corporate bond excess returns over duration-matched Treasuries during the past twelve months have been strongly positive: +316bps for IG and +844bps for HY. Our past work analyzing U.S. credit cycles has shown that such a positive return performance usually occurs during the deleveraging stage of the corporate credit cycle, typically during recessions when profits are falling and growth in company debt stalls or even contracts (Charts 6 & 7). Chart 6Investment Grade Corporate Annual Excess Return* Chart 7High-Yield Annual Excess Return* Chart 8Spreads Ignoring The Usual Credit Cycle The current environment is one of declining corporate profits but with debt growth still expanding, similar to the credit spread widening backdrop around the 2000 and 2008 U.S. recessions (Chart 8). This sends a similar message to the relationship of credit returns with capacity utilization, with corporate bonds now priced for a strong rebound in profit growth that may be difficult to achieve over the next year. A similar situation exists in the equity market, where the consensus bottom-up expectation is for overall profit growth to surge to +13% in 2017 and +11% in 2018.4 That would represent a sharp rebound from the profit declines witnessed in 2015 and the first half of 2016. Chart 9A Stretched Rally In U.S. Junk Some may argue that such a significant rebound in overall corporate earnings could happen just from the impact of better outlook for profits in the Energy sector given the recent recovery in oil prices. However, it appears that U.S. corporate bond valuations already more than fully discount a higher crude price. The 2016 rally in U.S. junk bonds has been led by the massive tightening of spreads of oil-related names, with the benchmark Bloomberg Barclays High-Yield Energy index returning 33% year-to-date as spreads have collapsed. However, the current Energy index OAS is at 550bps - levels last seen during the 2015 counter-trend rally in oil prices after the 2014 plunge (Chart 9, middle panel) That rally took the Brent crude price of oil up to $67/bbl, well above the current price hovering around $50/bbl. Our Commodity strategists continue to see $60/bbl as being the ceiling for the oil price range over the next year, as prices above that would begin to draw supply back into the market from U.S. shale companies and other global oil producers with higher break-even prices. Thus, U.S. HY energy debt already discounts an oil price that is unlikely to be achieved in the medium-term. A similar situation exists when looking at non-Energy junk spreads, which are highly correlated with macro volatility measures like the VIX index and which already fully reflect the current low volatility backdrop (Chart 9, bottom panel). We are concerned about a pick-up in volatility in the near-term from either a political surprise like a Trump victory on November 8 or, more likely, market jitters when the Fed delivers on a rate hike in December. With our fundamental VIX model, which is based off the lagged impact of rising corporate leverage and tightening monetary conditions, continuing to signal that the fair value level of the VIX is around 20, credit markets are not prepared for a potential rise in volatility in the next few months. Challenging Valuations At All Levels When we look at our various valuation gauges for U.S. corporate debt, it is difficult to find many areas where credit looks cheap. With regards to IG debt, our preferred measure of valuation is the 6-month breakeven spread, which shows how much spreads would need to widen to full offset the carry advantage of owning IG debt over duration-matched U.S. Treasuries, assuming spread volatility is maintained at recent levels. That breakeven spread now sits at a mere 9bps (Chart 10, top panel), well below the long-run mean. In other words, IG excess returns can easily turn negative with only a modest widening of spreads. For HY debt, our preferred valuation metric is the default-adjusted spread, where we subtract expected default losses estimated by our default rate and recovery rate models from the current junk spread. That adjusted spread is now only 69bps - a level more than one standard deviation below the long-run mean that we consider to be overvalued (bottom panel). With spreads at such depressed levels relative to expected default losses, the historical probability of junk delivering positive excess returns over the next year is extremely low. We see a similar stretched valuation backdrop when looking at credit spreads among sectors and ratings cohorts. Within the IG universe, the OAS for Financials, Industrials and Utilities have fully converged (Chart 11, top panel), while credit spread curves are near the tranquil 2005-2007 period of historically low volatility that we do not expect to be repeated (bottom panel). Within sectors, our U.S. IG relative value model only sees attractive spreads in the debt of Banks, Energy, Metals & Mining, Building Materials, Technology and Airlines. Chart 10Expensive Valuations, Especially For Junk Chart 11Not Much Difference To Choose From Here Bottom Line: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and corporate profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: ECB Buying Keeping IG Rich While Junk Fundamentals Worsen Turning towards Europe, a similar story of expensive corporate credit valuations exists, although not to the same magnitude as in the U.S. Of course, valuations may not matter for Euro Area IG with the European Central Bank (ECB) buying corporate debt as part of their quantitative easing (QE) asset purchase program. That surge in QE buying (both real and anticipated by investors) helped drive both yields and spreads for Euro Area IG sharply lower between March and June of this year. Since then, however, both yields and spreads have gone up moderately (Chart 12), reflecting both the rising global yield backdrop and the worsening situation for Euro Area banks whose debt dominates the IG market. Chart 12Euro Area Corporate Bond Rally Has Stalled Chart 13Euro Area Valuations Are Not That Cheap The rise in Euro Area corporate credit spreads comes at a time when investors have grown increasingly concerned about a potential tapering of the ECB's QE when the current program expires in March of next year. As we discussed in our previous Weekly Report, we expect the ECB to announce in December an extension of the government bond QE to at least September 2017, likely with some additional changes to the rules of the QE program to avoid hitting any self-imposed purchase limits.5 This could help keep spreads anchored near current levels, all else equal. Of course, all else is never equal, and the liquidity story can be trumped by expensive valuations, as we currently see in U.S. junk bonds. Using the same metrics for U.S. IG and HY credit spreads that we presented earlier shows that both the breakeven spread for Euro Area IG, and the default-adjusted spread for Euro Area HY, are below the long-run mean (Chart 13). Euro Area junk valuations are not as stretched as U.S. junk valuations on this basis, but they are hardly cheap. A similar story exists when looking at Euro Area IG corporates grouped by credit rating, with spread curves looking as flat as the U.S. curves shown earlier (Chart 14). Our Euro Area IG sector relative value model (Table 1 on Page 11) is also showing a handful of sectors with comparatively cheap spreads, ranging from commodity-focused industries (Energy, Metals & Mining) to financial groups (Insurers, Banks). However, the "cheapness" in the latter likely represents some degree of risk premium on Euro Area banks, whose poor profitability and capital adequacy issues are now well known to investors. Euro Area bank spreads may stay cheaper for longer until those problems begin to be addressed. Chart 14Euro Area Credit Spread Curves Are Flat Table 1Euro Area Investment Grade Corporate Sector Spread Valuations One final note on the relative value between Euro Area and U.S. corporates: the bottom-up Corporate Health Monitors for both regions that we introduced earlier this year continue to show gaps favoring Euro Area IG over U.S. equivalents (Chart 15), and U.S. HY over Euro Area equivalents (Chart 16). The relative balance sheet trends are showing up in the relative investment performance across the Atlantic, with Euro Area IG starting to outperform U.S. IG, and Euro Area HY lagging the returns in U.S. HY. We continue to recommend allocations based on these relative valuation trends, keeping the lightest weighting on Euro Area junk bonds that score poorly on all relative balance sheet metrics. Chart 15Favor Euro Area IG Over U.S. IG Chart 16Euro Area Junk Is Unattractive Vs. The U.S. Bottom Line: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay up in quality in Euro Area corporates, favoring Investment Grade over High-Yield. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "A Note On The Long-Term Outlook For Global Bonds", dated July 27, 2016, available at gfis.bcaresearch.com and usbs.bcaresearch.com 2 A neutral reading of the MCI is the zero line is consistent with a U.S. economy without any output gap, growing at its potential rate, and with unemployment at full employment levels. 3 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated Nov 1, 2016, available at usbs.bcaresearch.com 4 Source: Thomson Reuters I/B/E/S 5 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated Oct 25, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Beyond early last century's military rearmament, the idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis. If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global (but especially U.S.) defense stocks as a structural play will pay handsome dividends. The early-1960s experience in U.S. aerospace & defense (A&D) stocks is the closest stock market parallel we found in our analysis (given data constraints). Then, relative performance was up over 100% in a span of four years, as U.S. A&D industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95%. A&D factories were humming, racing to fulfill orders as U.S. military expenditures boomed. That demand surge translated into a jump in sector sales and given the industry's high operating leverage, earnings and book values soared. The chart shows that from trough to peak, sector EPS rose by more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled. That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the BCA U.S. defense index (that is a pure play on global defense spending). Bottom Line: Stay overweight the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL), and please see yesterday's Special Report for additional details.