Economy
Highlights U.S. Treasuries: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Contagion: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 2014/2015 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Feature Chart of the WeekBond Yields Following Inflation & QT, Not EM Have investors become too complacent? The selloff in emerging market (EM) assets is intensifying. The White House is threatening to slap tariffs on virtually all Chinese imports in the U.S. Accelerating wage and price inflation in the U.S. is keeping Fed rate hikes in play. The divergence between the strong U.S. economy and the rest of the world is growing wider, keeping the U.S. dollar elevated. Yet despite all that, non-EM markets show a surprising lack of concern over the EM volatility. U.S. equity indices remain close to all-time highs, while corporate bond spreads in the major developed markets are generally stable. Government bond yields remain well above levels implied by measures of economic sentiment like the global ZEW expectations index (Chart of the Week). For yields, the big issue remains, as always, the outlook for inflation and monetary policy. On that note, yields are being supported by inflation expectations, which have been boosted by faster realized inflation, tight labor markets and high oil prices. These trends are most pronounced in the U.S., where the Fed is not only hiking rates but also slowly reducing the size of its swollen balance sheet. This comes on top of the diminished pace of asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ), with the former still on track to end its net new buying of bonds at the end of the year. Against that backdrop of rising inflation and tightening global liquidity conditions, it is incorrect to solely make comparisons between today and the most recent period of EM weakness in 2014/15 that eventually spilled back violently into non-EM markets and caused the Fed to pause after only its first post-QE rate hike. The current backdrop also has similarities to the 2013 "Taper Tantrum", when the Fed surprised the markets by signaling that it was considering ending QE, triggering a spike in Treasury yields and a selloff in global risk assets. Chart 2China Remains The Key To Global Growth Then, global growth was accelerating and inflation expectations were at levels consistent with policymaker targets in the U.S. and Europe, yet central bank liquidity was slowing rapidly (mostly due to a contracting ECB balance sheet at a time when the Fed's balance sheet growth had already slowed). EM markets sold off alongside the rapid rise in U.S. Treasury yields during the Taper Tantrum. Yet with global growth accelerating and the U.S. dollar staying relatively stable, the EM selloff ended when the Fed delayed the start of the taper into 2014, providing a monetary boost to a global economy that did not need it. Today, realized inflation is even faster and central bank liquidity is again slowing rapidly. Yet market-based inflation expectations are still a bit below central bank targets, while non-U.S. growth expectations are slowing. Worries about the impact on the world economy from the brewing U.S.-China trade war are clearly weighing on the latter. The wild card will be how China responds to the tariff threat through policy stimulus. Already, China's policymakers have allowed some depreciation of the renminbi, along with some modest easing of monetary and fiscal policies, to counteract the growth threat from the Trump tariffs. BCA's China experts do not expect anything close to the massive 2015/16 package of fiscal/monetary stimulus, given the stated goal of President Xi Jinping to crack down on systemic financial risk.1 Yet the most recent figures on Chinese import growth, and higher-frequency data incorporated in the Li Keqiang index, are showing some reacceleration after the 2017 slowdown (Chart 2). At the same time, the most recent data point on the OECD's global leading economic indicator is potentially stabilizing (middle panel). A continuation of these trends could help reverse the cooling of non-U.S. growth seen so far in 2018 (bottom panel). Given all the uncertainties surrounding the U.S.-China trade battle, EM volatility and Chinese growth - at a time when global QE has turned into "QT", or "quantitative tightening", with an associated reduction in global capital flows - we continue to recommend only a neutral stance on global spread product, favoring U.S. corporates vs non-U.S. equivalents (especially avoiding EM credit). We also are maintaining our strategic recommended underweight stance on overall developed market duration, but favoring countries where monetary tightening will be more difficult to deliver (overweight U.K., Japan and Australia versus underweight U.S., euro area and Canada). A Quick Update On U.S. Treasuries: Stay Defensive Chart 3Stronger U.S. Growth = UST Underperformance The main U.S. data releases last week, the ISM surveys and the Payrolls report for August, came as a big surprise for the U.S. Treasury market. The headline ISM Manufacturing index hit a 17-year high of 61, led by increases in both the growth and inflation sub-components of the index (Chart 3), while the U.S. economy added another 200k jobs. The big shock came from the wage data in the Payrolls report, with Average Hourly Earnings rising by 0.4% in August, pushing the year-over-year growth rate to 2.9%, the highest since 2009. The Treasury market responded to data as expected, with the 10-year yield rising back to 2.94%. One of our favorite chart relationships shows the ISM Manufacturing index as a leading indicator of the momentum (12-month change) of core CPI inflation in the U.S. (Chart 4). The recent acceleration of U.S. core inflation can be explained as a lagged response to the U.S. economic growth acceleration since the start of 2016. If the relationship in this chart holds up, the current levels of the ISM are consistent with core CPI inflation accelerating to the 2.5-3% range next year. That outcome would keep the Fed on its planned rate hike path in 2019. At the moment, the market pricing of Fed rate expectations in the Overnight Index Swap (OIS) curve remains below the latest FOMC projections for the funds rate for the next two years (Chart 5). The 10-year TIPS breakeven inflation rate, which now sits at 2.1%, is still priced below the 2.3-2.5% levels that, in the past, have been consistent with inflation expectations staying well-anchored around the Fed's 2% inflation target. A combination of accelerating U.S. growth, faster wages, and a market that has not fully discounted the likely outcome for inflation and the funds rate is not a bullish one for U.S. Treasuries. We acknowledge that there could be a short-term flight-to-quality bid for Treasuries if the EM turbulence becomes more violent and finally spills over into the U.S. markets (likely through a rapid rise in the U.S. dollar). Yet without any signs of a meaningful slowing of U.S. growth or inflation, such a move would prove to be a short-lived trading opportunity rather than a true change in the rising trend for bond yields. Chart 4U.S. Inflation Acceleration Will Continue Chart 5Market Still Underpricing Fed Rate Hikes Bottom Line: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Turmoil, Then & Now, In Charts As discussed earlier, we see signs today of both of the most recent EM selloffs in 2013 and 2014/15 that were fueled by rising U.S. interest rates and a higher U.S. dollar. In the sets of charts beginning on Page 7 we present "cycle-on-cycle" analyses of several economic and financial indicators during those episodes, as well as this year. The charts are set up so that the blue lines represent the current EM selloff and the dotted lines in each panel represent how the same data series responded in 2013 (top panel of each chart) and 2014/15 (bottom panel of each chart). The vertical line represents the date of the trough in the U.S. dollar for each episode, which occurred in February 2018 for the current cycle. By looking at these charts, we can see how the current backdrop is evolving versus those prior episodes. The goal is to try to determine where things are similar, and different, to EM market declines in recent history. We are focusing on the areas where we believe there is the greatest concern over the potential spillovers from the current bout of EM stress - U.S. economic growth, Chinese economic growth and U.S. financial markets. We present the charts in a rapid "chartbook" format, with our overall conclusions at the end. Leading Economic Indicators: The OECD's leading economic indicator for the U.S. (Chart 6A) is currently off the high seen at the beginning of the year, following a path similar to 2014/15, but the latest data point has ticked higher. More importantly, the level is higher than at the same point in the 2013 and 2014/15 cycles. Meanwhile, the OECD (ex-U.S.) global leading economic indicator (Chart 6B) is following the depressed path of the 2014/15 episode, rather than the acceleration seen during the 2013 Taper Tantrum. Chart 6AU.S. Leading Indicator Following 2014/15 Path Chart 6BGlobal Leading Indicator Following 2014/15 Path U.S. Dollar: The rising dollar of 2018 (Chart 7A) looks more like the 2014/15 episode in terms of magnitude, although the greenback is at a lower level than during that earlier cycle (note that all lines are indexed to 100 at the date of the trough in the dollar at the vertical line). In 2013, the increase in the dollar was fairly mild, even with U.S. bond yields soaring higher, due to fact that non-U.S. growth was improving at the time. Chart 7AU.S. Dollar Following 2014/15 Path...So Far Chart 7BU.S. Investment Grade Returns Matching 2014/15 Path U.S. Corporate Bonds: The path of excess returns for U.S. investment grade corporate debt (Chart 7B) is tracking extremely tightly to the 2014/15 experience, with larger losses compared to this similar point during the Taper Tantrum. EM Equities & Credit: The widening in USD-denominated EM sovereign credit spreads in 2018 (Chart 8A) is in line with the 2014/15 cycle and has already surpassed the 2013 episode. The decline in EM equities (Chart 8B) has been worse than both prior EM selloffs. Chart 8AEM Equities Worse Than Both 2013 & 2014/15 Chart 8BEM Spreads Matching 2014/15 Path U.S. Interest Rates: Our 12-month fed funds discounter, which measures the amount of Fed rate hikes expected by the market over the next year, is higher than the 2014/15 episode and much higher than 2013 (Chart 9A). 10-year Treasury yields are at the same level as occurred at this point during the Taper Tantrum, and well above the levels seen in 2014/15 (Chart 9B). Chart 9AMore Fed Hikes Expected Than 2013 & 2014/15 Chart 9BUST Yields Following 2013 Path U.S. Labor Markets: Perhaps the biggest difference between the current backdrop and the prior EM selloffs is state of the U.S. labor market. The unemployment rate of 3.9% is much lower than the 5.6% rate seen during the 2014/15 cycle and the 7.6% level seen at this point during the Taper Tantrum (Chart 10A). That is translating to a faster pace of U.S. wage growth, measured by the annual percentage change in Average Hourly Earnings, than in either of the previous episodes of USD strength and EM turmoil (Chart 10B). Chart 10AMuch Lower U.S. Unemployment In 2018... Chart 10B...With Faster U.S. Wage Growth U.S. Inflation: Realized U.S. inflation, using core CPI, is higher now than in either of the previous episodes (Chart 11A). That can also been seen in the ISM Prices Paid index, which is far above the levels seen in both 2013 and 2014/15 (Chart 11B). Chart 11AHigher U.S. Inflation In 2018... Chart 11B...With Greater Inflation Pressures U.S. Economy: We can obviously show many charts here, but we think the most relevant are those related to signs that non-U.S. market turmoil and slowing growth is spilling back into the U.S. On that note, we show the ISM New Orders index in Chart 12A and the annual growth rate of total U.S. exports in Chart 12B. The New Orders index today is as strong as it was at this point during the Taper Tantrum, and much healthier compared to 2014/15 when New Orders were falling sharply. U.S. export growth is faster than both prior episodes, especially 2014/15 when exports contracted outright. Chart 12AStronger ISM New Orders In 2018... Chart 12B...With Healthier Export Demand China Economy: Again, we could use any number of data series in these charts, but we are keeping it simple and choosing indicators that show the impact of Chinese growth on the world economy. Chinese nominal GDP growth, currently at 9.8%, is the same as it was at this point in the 2013 cycle but much faster than during the 2014/15 period (Chart 13A). Importantly, however, China nominal GDP growth is decelerating now as it was in both of the prior episodes. Chinese annual import growth, up 19% in RMB terms, is faster now than in both prior periods of EM stress, especially compared to the contraction seen during the 2014/15 episode (Chart 13B). Chart 13AFaster, But Still Slowing, China GDP Growth Chart 13BStronger China Import Growth In 2018 U.S. Corporate Profits: Here is perhaps the biggest difference between today and the previous EM stress episodes. The annual growth in earnings-per-share for the S&P 500 rose to 18% in the 2nd quarter of this year, far above the zero growth rate seen at this point of the 2013 and 2014/15 cycles (Chart 14A). A big reason for the difference is the impact of the Trump corporate tax cuts this year, which has boosted operating margins well beyond levels seen in the prior two episodes (Chart 14B). Chart 14AFaster U.S. Profit Growth In 2018... Chart 14B...With Wider Margins Thanks To Tax Cuts EM Growth: An aggregate of EM Purchasing Managers Indices (PMIs) shows that the current bout of softer EM growth looks similar to the slowdowns in 2013 and 2014/15 (Chart 15A). In both prior cases, the PMIs eventually fell below 50, signifying economic contraction. In the 2013 episode, however, the PMI rebounded around the same point in the cycle as we are at today. Chart 15AEM Growth Slowing Similar To 2013 & 2014/15 Chart 15BU.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions: U.S. financial conditions are tighter now than the level seen at this point in the 2013 cycle and are as tight as witnessed at this point in the 2014/15 period (Chart 15B). After looking through all these charts, we can come up with the following conclusions: Chart 16Is It All Just "Q.T."? EM financial stress today is worse than 2013 and 2014/15 The U.S. economy is stronger today than in 2013 and 2014/15 U.S. external demand and corporate profits are both more robust today than in 2013 and 2014/15 U.S. inflation pressures are greater today than in 2013 and 2014/15 China's economy today, while slowing, is still growing faster than in 2013 and 2014/15 EM economic growth is slowing at the same pace as in 2013 and 2014/15. In terms of "benchmarking" where we are now compared to the previous two EM big EM selloffs, the fact that U.S. and Chinese economic growth is stronger today, and U.S. inflation is faster today, are the most important differences. This may even explain why U.S. markets are not reacting more negatively to the growing protectionist threats from the White house. Against this backdrop, it will require higher U.S. interest rates and a much stronger dollar before U.S. equities and credit markets finally suffer a serious pullback. In the end, though, the fact that U.S. and Chinese growth is better today does not suggest that a cautious investment stance is unwarranted. For the best correlation can be seen in our final chart (Chart 16), which shows the growth rate of the major developed market central bank balance sheets as a leading indicator of EM equity returns and developed market credit returns (and as a coincident indicator of government bond yields). If one were to only look at this chart, the weaker returns from global risk assets in 2018 can be fully explained by "quantitative tightening" and the resulting pullback in risk-seeking global capital flows compared the 2016/17. Bottom Line: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 204/15 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Last week's View Meeting underlined the point that BCA's take on the macro backdrop hasn't changed. Decelerating global growth and the potential for a nasty EM debt episode still argue for slightly cautious asset allocation. Global desynchronization is in full swing, with the U.S. leading the other major DM economies by a wide margin. The growth disparity will be dollar-positive while it lasts, but the deteriorating U.S. budget position will weigh on the dollar in the long run. S&P 500 performance across the earnings cycle reveals that decelerating earnings growth is not a problem for stocks as long as earnings are still growing year-on-year. Acceleration beats deceleration, but peaking earnings growth is not a signal to trim equity exposures. The U.S. is not impervious to a meaningful EM credit event, but its direct exposures are very limited. Post-crisis banking regulations have meaningfully reduced the banking system's vulnerabilities and make it very unlikely that another LTCM-like event might occur. Feature BCA researchers convened last week for our monthly View Meeting with the explicit goal of taking stock of our strategy teams' macro views. The nine-year-plus U.S. expansion is well advanced, and we are carefully monitoring the business cycle, the credit cycle, and the policy cycle for early warning of inflections in the rates, credit, and equity markets. In addition to the regular cyclical movements, we also have to gauge the impact of the ongoing reversal of extraordinary monetary accommodation and a raft of geopolitical issues. The investment outcome of the many crosscurrents continues to be subject to spirited debate, but the warily constructive house view, in place since mid-June, was not challenged. Decelerating global growth was a key driver of our June downgrade to neutral on equities. The U.S. economy may be surging as two years of fiscal stimulus makes its presence felt, but the other major developed-world economies are softening, and the emerging-market bloc faces considerable pressure. Although the S&P 500 has since made new highs (Chart 1, top panel), the MSCI All-Country World Index ("ACWI") has gone nowhere (Chart 1, second panel). Within the ACWI, DM equities (Chart 1, third panel), have handily outperformed struggling EM equities (Chart 1, bottom panel). We continue to expect more of the same. Tax cuts will keep corporate profits growing at better than 20% for the rest of the year, and federal spending will boost the U.S. economy through the end of 2019. The pickup in aggregate demand will strain dwindling spare capacity, feeding inflation pressures, and keeping the Fed from easing up on its rate-hiking campaign. A resolute Fed will ratchet up the pressure on EM borrowers, while increasing trade barriers pose a headwind for the many DM and EM economies that are more open than the U.S. Chinese policymakers could provide some respite to the global economy, but our China and EM strategists aren't counting on it. Easing monetary and/or fiscal policy would run counter to the Party's ongoing deleveraging and anti-corruption campaigns (Chart 2). Though China's rulers have demonstrated a tendency to overreact when acting to offset adverse economic events, our in-house experts think conditions will have to get a good bit worse to provoke meaningful stimulus of any sort. The strike price on a Chinese policy put may be considerably out of the money. Chart 1So Far, So Good Chart 2Will They Swim Against The Tide? Bottom Line: Overindebtedness, rising trade barriers, and a U.S. economy with the potential to overheat will keep the pressure on the EM bloc and cast a shadow over global growth. The Chinese policy cavalry may not feel any particular urgency to ride to the rescue. Leading The Pack There was no dispute about the U.S. growth outlook, absolute or relative. The U.S. economy is flying high, and will continue to outdistance its DM peers for the rest of this year and next. S&P 500 EPS growth will maintain its better than 20% pace in the third and fourth quarters. Next year's 10% consensus may be ambitious, given that this year's dollar appreciation probably hasn't shown up in earnings data, but corporate management teams have not yet expressed much in the way of dollar concerns. Decoupling cannot go on forever in the 21st-century global economy, but the comparatively closed U.S. economy has room to run in the near term. Last week's August ISM Manufacturing survey reached a 14-year high while the global PMI continued to hook lower (Chart 3). The gap between the U.S. LEI index and the global ex-U.S. LEI index has been widening for over a year (Chart 4), and would seem to herald additional dollar strength (Chart 4, bottom panel). Our corporate earnings models see U.S. EPS growth widening its lead on Europe and Japan over the rest of the year (Chart 5). Chart 3You Go Your Way And I'll Go Mine Chart 4Dollar Strength... Chart 5...Hasn't Gotten In Earnings' Way Yet Bottom Line: The U.S. is outgrowing its developed market peers, and there is nothing on the immediate horizon that suggests a reversal is in store. Superior corporate earnings growth and dollar strength should allow U.S. equities to outperform their major DM peers on a common-currency basis well into 2019. The Change, Or The Change Of The Change? Deceleration has been at the heart of BCA's managing editors' concerns, and there is an intuitive appeal to the idea that equity markets prize the change of the change (the second derivative) over the first-order move itself. It has the potential to clash, however, with the empirical fact that stocks typically rise unless earnings are contracting. To determine the degree to which decelerating earnings growth has historically presented a challenge to the S&P 500, we posit a four-phase earnings cycle based on the interaction between earnings-estimate growth and acceleration (Diagram 1), as follows: Diagram 1The Earnings Cycle Phase I begins when the worst part of the cycle has ended. Earnings estimates are contracting on a year-over-year basis, but at a slowing rate. Because earnings typically grow, and the bounce off the bottom is typically swift, this phase has occurred just 8% of the time. In Phase II, year-over-year earnings are growing at an accelerating rate. In Phase III, year-over-year earnings are still growing, but at a slowing rate. Phase II and Phase III are the de facto default phases, each accounting for 39% of all observations. In Phase IV, year-over-year earnings are contracting at an accelerating rate. Phase IV is more common than Phase I because the decline to the bottom tends to unfold more slowly than the bounce off of it, but it still occurs just 14% of the time. Table 1 shows annualized S&P 500 price returns for each phase of the cycle and then groups the phases by acceleration/deceleration and expansion/contraction. Stocks perform better when the rate of earnings growth is accelerating than they do when it's decelerating, but they also perform better when earnings are growing on a year-over-year basis than they do when they're declining. Stocks perform terribly when earnings are falling year-on-year at an increasing rate (Phase IV), and do great when the pace at which they're falling slows (Phase I), but those occurrences are few and far between. Earnings grow four-fifths of the time, and when they do, the differences between accelerating and decelerating growth aren't all that big a deal (Chart 6). Table 1Acceleration Is Better, But Deceleration Isn't All Bad... Chart 6...As It's Not A Problem As Long As Earnings Still Grow Bottom Line: Deceleration in the rate of earnings growth is not a signal to abandon stocks as long as earnings are still growing year-on-year. Investors have fared well for 40 years when earnings estimates expand, regardless of whether the rate of expansion is accelerating. 2018 Is Not 1997-98 In the wake of August's wobbles, several clients have been eager to explore various EM economies' vulnerabilities1 in more detail. We have fielded several questions relating to U.S. banks' EM exposures and how they compare to their exposures to the Asian Tigers on the cusp of the Asian Crisis. Per data from the Bank for International Settlements and the FDIC, U.S. claims on Thailand, Indonesia, the Philippines, Singapore, Malaysia, South Korea and Taiwan amounted to about 14% of all U.S. bank credit at the end of 1996. That exposure is very similar to the U.S. banking system's current exposure to Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa, and Indonesia. Direct exposure to fragile EM economies did not drive the S&P 500's 19% decline across July and August of 1998, however, nor did it inspire a consortium of fourteen major global financial institutions to come together to attempt to ring-fence the U.S. banking system. Those outcomes can be laid to the brokers' and investment banks' indirect exposure to the massively leveraged investment portfolio of the Long-Term Capital Management hedge fund (LTCM). To gauge the system's fragility back then, we perform a simple comparison of LTCM's debt to the publicly traded U.S. investment banks' total equity. In our back-of-the-envelope analysis (Table 2), we assume that the four investment banks, which contributed a quarter of the funds to rescue LTCM, had provided at least a quarter of LTCM's financing.2 Per our assumptions, LTCM claims accounted for 82% of the four banks' total equity. Losses given default would not have been anywhere near 100%, but a disorderly exit from LTCM's positions would surely have forced several of LTCM's creditors to conduct urgent capital raisings of their own. Fortunately for investors, today's banking system is nowhere near as vulnerable. Investment bank leverage ratios of 30 or more, commonplace in the late '90s, are a practical impossibility today. While lenders are no less likely to chase business late in the cycle today, post-crisis regulation makes it far more difficult to indulge their folly. Today's investment banks operate with a third of the leverage of 20 years ago (Table 3). The odds that another overextended investor, or group of investors, could imperil the U.S. banking system are much longer today than they were then. It's considerably harder to come by leverage via the regulated banking system, and leverage is the essential contagion ingredient. Table 2Enormous Leverage Made The Banking System Unstable In The Summer Of 1998 ... Table 3... But It's Not A Problem Anymore Bottom Line: Basel III, Dodd-Frank and the Volcker Rule save lenders from their own worst impulses. The odds of another LTCM crisis are far slimmer than they were in the late '90s. Investment Implications We continue to have a constructive view of the business, market and policy cycles in the U.S., but there's more to the global investing backdrop than just the U.S. Global investors should overweight U.S. equities versus equities in the rest of the world and U.S. investors should be sure to be at least equal weight equities, but the environment is sufficiently risky to inspire caution. We join our colleagues in continuing to recommend a benchmark equity allocation, while underweighting bonds and overweighting cash. August's employment report supports our economic and investment takes. The labor market remains tight, with the broader U-6 definition of unemployment (including involuntary part-time and discouraged workers) making a second straight 17-year low (Chart 7, top panel), and average hourly earnings extending their slow march higher (Chart 7, bottom panel). With the three-month moving average of payrolls (185,000) expanding at a rate well above the 110,000-per-month pace required to absorb new entrants to the labor market, qualified candidates are going to become even more difficult to find. The upshot is that the Fed remains firmly on a path to hike rates more than the market consensus currently expects. Despite the potential for a near-term flight-to-safety bid for Treasury bonds, we are sticking with our below-benchmark duration call. Chart 7As Slack Is Absorbed, Wages Will Rise Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 20, 2018 U.S. Investment Strategy Weekly Report, "Rude Health," available at usis.bcaresearch.com. 2 Lehman did not contribute to the bailout, but it is highly improbable that it had not lent to LTCM.
Highlights The U.S. has outperformed most major stock markets over the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. U.S. companies will continue to deliver superior earnings growth during the remainder of this year. However, profit growth is likely to slow in 2019 owing to a larger wage bill, a stronger dollar, and a sluggish global economy. The efficacy of buybacks in boosting earnings-per-share is waning due to soaring valuations and rising interest rates. For the time being, asset allocators should maintain a neutral weighting to global equities, while favoring developed market stocks over emerging markets and overweighting defensive sectors relative to cyclical ones. Within the developed market equity space, the U.S. will outperform over the coming months in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, odds are high that earnings growth in the rest of the world will catch up with that of the U.S. Feature There Is No Mystery As To Why U.S. Stocks Have Outperformed The stock market is influenced by many variables, but in the end, the one that matters most is earnings. The U.S. has outperformed most major stock markets during the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. Stronger earnings growth, in turn, has caused investors to assign a higher earnings multiple to the U.S. in comparison to other regions. This has given U.S. stocks a further lift (Chart 1). Differences in sector weights have helped flatter overall U.S. earnings to some extent. Globally, earnings in the tech and health care sectors have grown much more quickly than earnings in the financials and materials sectors (Chart 2). The former sectors have large weights in U.S. indices, while the latter are overrepresented in overseas indices (Table 1). Still, our analysis suggests that most of the outperformance of U.S. firms can be explained by their superior earnings growth within sectors (Chart 3). Chart 1U.S. Stocks Have Outperformed ##br##Thanks To Faster Earnings Growth Chart 2Global Earnings Sector Breakdown Table 1Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials ##br##And Materials Are Overrepresented In Markets Outside The U.S. Chart 3AU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (I) Chart 3BU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (II) We do not expect U.S. corporate earnings growth to slow sharply this year. In fact, our margin proxy points to a slight increase in profit margins in the second half of the year (Chart 4). Nevertheless, there are four reasons why U.S. earnings growth will decelerate in 2019 and beyond: Wage growth is likely to pick up. Chart 5 shows that there is an almost perfect correlation between profit margins and the ratio of selling prices-to-unit labor costs. A variety of surveys suggest that U.S. firms are struggling to find qualified workers (Chart 6). This is confirmed both by the most recent Fed Beige Book and by firms' Q2 earnings conference calls. A stronger dollar will eat into earnings. A reasonable rule of thumb is that every 5% appreciation in the broad trade-weighted dollar reduces S&P 500 earnings by 1% over the course of the ensuing 12-to-18 months. The broad trade-weighted dollar has risen 6.2% so far this year and we expect further strength in the months ahead. Global growth will weaken further. The U.S. is increasingly running out of spare capacity, which is limiting domestic growth prospects. Emerging markets are struggling, with the crises in Turkey and Argentina likely to spread to bigger players such as Brazil and South Africa. A major Chinese stimulus package would help reboot global growth, but concerns about high debt levels, overcapacity, and an overheated housing market will limit the response. The policy environment will become more challenging. Corporate tax cuts helped boost earnings earlier this year. However, the regulatory landscape is likely to turn less benign over the next few years. The tech sector is facing increased scrutiny.1 New EU privacy rules came into effect in May, which will limit the ability of internet companies to harvest personal data. The Trump Administration is also increasingly targeting social media companies for allegedly suppressing conservative voices. In addition, our geopolitical strategists expect U.S.-China trade tensions to remain elevated, with the U.S. likely to impose tariffs on an additional $200 billion worth of Chinese imports. Meanwhile, a trade deal with Canada is no slam dunk. President Trump has even reiterated that he would be willing to exit the World Trade Organization. Chart 4Margins Could Rise A Bit More ##br##In The Near Term Chart 5Higher Wage Growth Will Undermine Profit Margins Chart 6U.S. Firms Are Having Difficulty ##br##Finding Qualified Workers Diminishing Returns From Buybacks U.S. companies are on track to spend a record amount of money buying back shares in 2018, with tech companies accounting for about 40% of all shares repurchased. While this may seem very bullish for stocks, one should keep in mind that the prior peak in share buybacks occurred in 2007. Companies are not particularly adept at timing the stock market, even when it is their own shares they are purchasing. Moreover, U.S. stock market capitalization has doubled since 2007. As a share of market cap, today's pace of buybacks is high, but not exceptionally so (Chart 7). To state the obvious, the more expensive stocks get, the more money it takes to purchase the same number of shares. U.S. equity valuations are quite stretched by historic standards (Chart 8). On a price-to-sales basis, U.S. stocks are now as expensive as they were in 2000. Our estimate of the U.S. equity risk premium - calculated as the difference between the cyclically-adjusted earnings yield and the average expected short-term real interest rate over the next decade - is well below its historic average (Chart 9). Chart 7Buybacks As A Share Of Market Cap: Fairly Muted Chart 8U.S. Equities Are Trading At Lofty Valuations Chart 9The U.S. Equity Risk Premium Is Well Below Its Historic Average It is also important to remember that share repurchases will only boost EPS if the interest rate that companies receive on their cash balances is below their earnings yield. To see this, consider a simple example where the earnings yield and the interest rate are the same. Specifically, suppose that a company has a market cap of $1 billion, $20 million in earnings, and earns 2% on its cash holdings. If the company buys back $100 million in shares, its share count will decline by 10%, but the interest payments that it receives will fall by $2 million, pushing profits down by 10% from $20 million to $18 million. The net result is no change in EPS. As U.S. interest rates continue to increase, companies will see ever-smaller benefits to their bottom lines from share buybacks. Where's The Earnings Growth Going To Come From? The foregoing discussion raises another point, which is that buybacks, by their very nature, leave companies with less cash to invest in future growth. This issue is quite relevant for the current environment. Analysts today expect the average S&P 500 company to grow earnings at an annual rate of 16.6% over the next 3-to-5 years (Chart 10). This is wildly optimistic. It is six points higher than the long-term earnings growth rate they expected just three years ago. Indeed, it is only topped by the euphoric projection of 18.7% reached in 2000 - just before the stock market came crashing down. Apparently, on Wall Street, companies can have their cake and eat it too. Chart 10Analyst Expectations Are Too Optimistic Creative Accounting? Earnings are earnings, correct? Actually, no. What constitutes earnings has changed over the years. Up until the 1990s, companies generally reported GAAP earnings - earnings based on Generally Accepted Accounting Principles. Over the past two decades, however, companies have moved towards reporting so-called "pro forma" or "operating" earnings. Unlike GAAP earnings, there is no codified set of rules governing the definition of operating earnings. Conceptually, companies are supposed to exclude both one-off losses and gains when calculating operating earnings in order to give shareholders a better sense of the underlying trend in profits. In practice, they tend to exclude the former much more often than the latter. This problem has gotten worse over time, so much so that an apples-to-apples comparison now requires that we reduce earnings today by about 15% in order to compare them with earnings in the early 1980s (Chart 11). More ominously, it is possible that even GAAP earnings are currently overstated. Chart 12 shows that EBITDA profit margins, which are generally more difficult to fudge, have fallen over the past decade, while operating margins have risen. Economy-wide profit margins, as measured in the national accounts, have also increased much more slowly than S&P 500 operating margins (Chart 13). Chart 11A Bull Market In Creative Accounting? Chart 12S&P 500 Operating Margins Have Risen Much More Than EBITDA Margins Chart 13Profit Margins, As Measured In The National Accounts, Have Fallen Relative To S&P 500 Margins This raises the risk that we will see more earning restatements - or at the very least, earnings disappointments - in the years ahead as companies run out of magic asterisks to pull out of their bag of accounting tricks. Investment Conclusions Corporate earnings are highly correlated with the state of the business cycle (Chart 14). We do not expect the U.S. to enter a recession at least until 2020. Thus, it is doubtful that U.S. earnings will suffer a sharp decline before then. Nevertheless, as this report argues, earnings growth is likely to decelerate early next year. Investors have a lot riding on the assumption that earnings growth will hold up. U.S. households owned nearly $30 trillion of equities in Q1 of 2018, or 25% of total household assets, the highest level since 2000 (Chart 15). The monthly asset allocation survey published by the Association of Individual Investors (AAII) shows that stocks comprised 68.5% of investors' portfolios in August (Chart 16). While this is below the peak of 77% reached in March 2000, it is still more than seven points above the post-1987 average of 61%, putting it in the 84th percentile of the historic distribution. Chart 14Earnings Are Highly Correlated ##br##With The Business Cycle Chart 15Households Are Loaded Up On Stocks Which... Chart 16...Comprise A Big Chunk Of Their Portfolios If earnings growth slows significantly, investors could end up deciding to cut their exposure to the stock market. Since for every buyer there must be a seller, the only way for investors to collectively reduce the value of their equity holdings is if share prices decline. U.S. equities account for 55% of global stock market capitalization (Chart 17). Thus, if U.S. earnings begin to stagnate, this will limit the upside for global equity indices. Chart 17U.S. Equities Account For More Than Half Of Global Stock Market Capitalization Chart 18Earnings In Other Regions Will Eventually Catch Up With The U.S. Does this mean that investors should look for greener pastures abroad? Not yet. We expect the dollar to strengthen and global growth to slow further over the coming months. This will put downward pressure on cyclical stocks, which are overrepresented in foreign indices. For the time being, asset allocators should maintain a neutral weighting to global equities, favoring developed market stocks over emerging markets. Within the DM space, the U.S. will outperform in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, we are more sanguine about the prospects for non-U.S. stocks. The outperformance of U.S. equities over the past decade follows a decade of underperformance. In fact, EPS in Europe and emerging markets actually grew more rapidly between 1990 and 2007 than in the United States (Chart 18). Historically, the relative growth of earnings across different regions follows multi-year cycles, and there is no reason to think that this will change. As such, it is likely that earnings growth in the rest of the world will begin to outstrip the U.S. once the problems plaguing emerging markets have been flushed out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see U.S. Equity Strategy, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China Chart 7Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising Chart 9BEM: Interbank Rates##br## Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Chart 5...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Most FOMC participants currently think that r-star is somewhere between 2.75% and 3%. If this is correct, it means that the Fed's current 25 basis point per quarter hike pace will cause the funds rate to reach neutral by the middle of next year. This is…
Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Chart 1All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Chart 5Decomposing... Chart 6...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Chart 9...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades
Highlights Monetary Policy: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Duration: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Fed Chairman Jerome Powell used his highly anticipated Jackson Hole address to reinforce the theme that has quickly become the hallmark of his tenure.1 Much like at the June FOMC press conference, the Chairman stressed the importance of incorporating uncertainty into the decision-making process.2 Specifically, the uncertainty surrounding real-time estimates of important macroeconomic variables such as the natural rate of unemployment (NAIRU) and the neutral (or equilibrium) fed funds rate. Chart 1The Fed's "Gradual" Rate Hike Cycle Uncertainty Surrounding NAIRU Considering the uncertainty surrounding NAIRU, the Chairman pointed to two specific time periods. The first being the "Great Inflation" of the 1960s and 1970s. In the late 1960s, real-time NAIRU estimates suggested that the unemployment rate was only slightly below its natural level, meaning that inflationary pressures were thought to be relatively muted (Chart 2). That expectation led policymakers to maintain an accommodative monetary policy that fueled the inflation of the 1970s. In Powell's view, the policy error was placing too much faith in real-time estimates of NAIRU, which with hindsight have been heavily revised (Chart 2, bottom panel). Chart 2Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers The second period Powell discusses is the late 1990s. This period is the opposite of the 1960s in the sense that real-time NAIRU estimates were eventually revised lower (Chart 2). At the time, labor markets were thought to be very tight. But former Fed Chairman Alan Greenspan downplayed real-time NAIRU estimates and kept monetary policy easier for longer than many would have liked. Powell argues that subsequent downward NAIRU revisions vindicated that decision. At present, the unemployment rate of 3.9% is considerably below the Fed's most recent median NAIRU estimate of 4.5% (Chart 3). Complete faith in that NAIRU estimate would suggest that the Fed should be aggressively tightening policy. But as in the 1990s, it is possible that current NAIRU estimates will eventually need to be revised down. Despite seemingly tight labor markets, year-over-year core PCE inflation has still not returned to the Fed's 2% target. This makes future downward NAIRU revisions currently appear more likely than future upward revisions. Chart 3Current Estimates Point To A Very Tight Labor Market Powell argues that the Fed's "gradual" tightening path - raising the fed funds rate 25 bps per quarter - is a way of splitting the difference. The process of lifting rates acknowledges the current NAIRU estimate, while the relatively slow pace hedges the risk that it turns out to be too high. Uncertainty Surrounding The Neutral Rate Chart 4Growth At Odds With The Yield Curve Other than NAIRU, policymakers must also deal with the concept of the neutral (or equilibrium) fed funds rate. This is the interest rate that will keep the economy growing at its potential, leading to neither inflationary nor deflationary pressures. At the moment, most FOMC participants think the longer-run neutral rate is somewhere between 2.75% and 3% (in nominal terms). If this is correct, it means that the Fed's current 25 bps per quarter rate hike pace will cause the funds rate to reach neutral by the middle of next year. This is illustrated by the shaded grey boxes in Chart 1. If we assume complete confidence in the current estimate of the neutral rate, it is obvious that unless inflation significantly overshoots the 2% target, the Fed should halt its tightening cycle next year when the funds rate hits neutral. In fact, some FOMC members are advocating for at least a pause. Dallas Fed President Robert Kaplan recently said that when the fed funds rate reaches the current estimate of neutral: I would be inclined to step back and assess the outlook for the economy and look at a range of other factors - including the levels and shape of the Treasury yield curve - before deciding what further actions, if any, might be appropriate.3 However, the importance Powell places on uncertainty makes us think that any such pause would be very brief, if it occurs at all. In a recent report we showed that while the slope of the yield curve is consistent with a monetary policy that is already close to neutral, economic indicators do not corroborate this message (Chart 4).4 Bottom Line: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Heading For A Slowdown? The catalyst that could actually derail the Fed's rate hike cycle would be a meaningful slowdown in U.S. economic growth. In this regard, we observed in a recent report that current weakness outside of the U.S. is likely to spill over.5 Since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5). Is there any reason to believe that this time might be different? One reason for optimism is that the Eurozone has been the main driver of the year-to-date slowdown in the Global Manufacturing PMI (Chart 6). This is encouraging because while Eurozone growth has certainly slowed, the PMI remains at a high level, well above the 50 boom/bust line. Further, recent data have shown some stabilization. The PMI is falling less rapidly than earlier in the year and broad money growth has picked up (Chart 7, top panel). However, weakness in China and emerging markets could easily swamp any positive impulse out of Europe. Though indicators of current economic activity in China appear in good shape, leading indicators and the imposition of tariffs point to weakness ahead (Chart 7, panel 2). Chinese policymakers have taken some steps to ease monetary conditions (Chart 7, bottom panel), but it remains unclear whether that will be sufficient to maintain current growth rates. Chart 5Global Growth Could Bring Down The U.S. Chart 6Weakness Due To Eurozone Chart 7The Biggest Risk Is From China Our assessment is that it is highly likely that weak global growth will eventually filter into the States. This will cause the Fed to pause its 25 bps per quarter tightening cycle at some point next year. However, applying Chairman Powell's uncertainty doctrine to our investment strategy, we must weigh this risk against what the market is already discounting. Chart 1 shows that the fed funds futures market is priced for a funds rate of 2.33% by the end of this year and 2.68% by the end of 2019. This means that the market is priced for only a single 25 bps rate hike in 2019, rather than the four we would expect in an environment of no economic hiccups. According to our golden rule of bond investing, we should be reluctant to adopt an above-benchmark portfolio duration stance unless we are confident that Fed rate hikes will come in below expectations over our investment horizon.6 Given that a significant growth slowdown would be required for the Fed to deliver only one hike in 2019, we think below-benchmark portfolio duration is still justified on a 6-12 month horizon. Bottom Line: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation Update An additional reason why any pause in the Fed's rate hike cycle could prove fleeting is that core inflation is very close to returning to the Fed's 2% target. Trailing 12-month core PCE inflation clocked in at 1.98% in July, while trailing 12-month trimmed mean PCE inflation was 1.99%. Rising inflation is likely the reason that long-dated TIPS breakeven inflation rates have remained stable in recent weeks, even as high-frequency global growth indicators have turned down (Chart 8). Looking ahead, the economic backdrop suggests that monthly inflation prints will continue to be strong. Our Pipeline Inflation Indicator remains elevated, despite the recent decline in commodity prices, and our PCE diffusion index shows that recent price increases have been broadly based (Chart 9). Chart 8Closing In On Target Chart 9Macro Environment Is Inflationary However, unless month-over-month inflation prints strengthen considerably, we should expect smaller increases in the year-over-year inflation rate going forward, as base effects provide less of a tailwind. To assess how much base effects influence year-over-year inflation rates we created our Core PCE Base Effects Indicator. We constructed the indicator using core PCE growth rates over horizons ranging from 1 to 11 months. We compare each growth rate to the growth rate over the next longest interval and increase the indicator's value by 1 each time a shorter-interval growth rate exceeds a longer-interval growth rate. In other words, we compare the 1-month growth rate in core PCE to the 2-month growth rate. If the 1-month growth rate is above the 2-month growth rate, we add 1 to our indicator. We then compare the 2-month growth rate to the 3-month growth rate, and so on. This gives us an indicator that ranges between 0 and 11. Chart 10 shows that when our Base Effects Indicator is elevated it usually means that year-over-year core PCE inflation will rise during the next six months, and vice-versa. We also observe that the cut-off point between positive and negative base effects is between 5 and 6. That is, when our indicator is at 6 or above, base effects bias the year-over-year core PCE inflation rate higher. Base effects tend to drag year-over-year inflation lower when our Indicator gives a reading of 5 or below. Chart 11 demonstrates the impact of base effects in more detail. The chart presents the median, first quartile and third quartile of 6-month changes in year-over-year core PCE inflation for each possible reading from our indicator. The median inflation change is positive for readings of 6 and above, and negative for readings of 5 and below. Chart 10Base Effects Now Less Of A Tailwind Chart 11The BCA Base Effects Indicator Tested (1960 - Present) In recent months, the reading from our Base Effects Indicator had been at 8, suggesting a very strong tailwind pushing the year-over-year growth rate in core PCE higher. But following last week's July PCE release our indicator fell to 6, suggesting only a mild positive impact from base effects going forward. Bottom Line: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2018-08-21/fed-s-kaplan-inclined-to-reassess-rates-amid-yield-curve-angst 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification