Economy
Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Table I-1Exit Checklist For Risk Assets U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... Chart I-5...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Chart I-7The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets Chart I-12Effect On Treasurys The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Chart II-7Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Dear Clients, Please note that next week's report will be a joint effort with our geopolitical team, focused on North Korea. The report will be sent to you two days later than usual, on Friday June 8. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights Most episodes of negative relative Chinese equity performance this year have been driven by global stock market selloffs or related to the trade dispute with the U.S. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, we recommend against downgrading China for now, barring hard evidence of a pernicious global slowdown or that severe protectionist action from the U.S. will indeed occur. Our list of charts to watch over the coming months highlights, among several other important points, that monetary conditions are not overly restrictive and that financial conditions are not tightening sharply. This is in spite of a recent clustering in corporate bond defaults that has concerned some investors. Besides broad-based stimulus in response to an impactful trade shock, a sustained pickup in housing construction remains the most plausible catalyst for an acceleration in domestic demand. For now tepid sales volume casts doubt on this scenario, but investors should continue to watch Chinese housing market dynamics closely. Feature There have been several developments affecting Chinese and global stock markets over the past two weeks. On the trade front, Secretary Mnuchin's statement on May 20 that the U.S. would be "putting the trade war" with China on hold was greeted by a material pushback from Congressional Republicans, particularly the administration's plan to ease previously announced sanctions on ZTE Group. The administration's trade rhetoric has since become more hawkish, as evidenced by yesterday's statement from the White House that referenced specific dates for the imposition of tariffs and the announcement of new restrictions on Chinese investment. This uptick in tough language sets the scene for Secretary Ross' Beijing visit this weekend to continue negotiations. More recently, a political crisis in Italy has caused euro area periphery bond yields to rise sharply, roiling global financial markets. The Italian President's rejection of Paolo Savona as proposed finance minister by the anti-establishment Five Star Movement (M5S) and Euroskeptic Lega has led to the installation of a caretaker government until the fall, when new elections are set to take place. The sharp tightening in financial conditions for Italy and Spain over the past week has exacerbated concerns about a potential growth slowdown in Europe, and has fed a relative selloff in emerging market equities that began in late-March. Despite the recent turmoil, our recommendation to investors is to avoid making any major changes to their allocation to Chinese ex-tech stocks within a global portfolio. Unless presented with hard evidence that the slowdown in the global economy is more than a simple deceleration from an above-trend pace, or that protectionist action from the U.S. will occur in a severe fashion, Table 1 suggests that investors should stay overweight Chinese ex-tech stocks (with a short leash). The table highlights that most episodes of negative relative Chinese ex-stock performance since the beginning of the year been driven by global stock market selloffs or related to the trade dispute with the U.S., despite the ongoing slowdown in China's industrial sector that we have repeatedly flagged. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, our interpretation is that investors are well aware of the deceleration in China's economy, but do not yet regard it as a material threat to ex-tech equity prices. Table 1YTD Weakness In Chinese Stock Prices Has Been Driven By Global Events Clearly, however, this assessment on the part of global investors can change, underscoring that the situation in China merits continual re-assessment. With the goal of providing investors with a toolkit to continually monitor the state of the Chinese economy and the resulting implications for related financial asset prices, this week's report presents a list of 11 charts "to watch" across five categories of analysis. In our view these charts span key potential inflection points for the economic and profit outlook, and will serve as an important basis for us to update our view on China over the months ahead. Monetary & Fiscal Policy Chart 1: The Policy Rate Versus Borrowing Rates Chart 1Borrowing/Policy Rate Divergence Should Not Last,##br## But Is Worth Monitoring An interesting divergence has occurred lately between the 3-month interbank repo rate (currently the de-facto policy rate) and both corporate bond yields and the average lending rate. While the repo rate fell non-trivially after it became apparent in late-March that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, corporate bond yields have recently risen sharply and China's weighted-average lending rate ticked higher in Q1. As we highlighted in last week's Special Report, the recent clustering of corporate bond defaults does not (for now) appear to be a source of systemic risk. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. But the possibility remains that the ongoing crackdown on China's shadow banking sector will cause some degree of persistence in the recent divergence between the interbank market and actual borrowing rates, implying that investors should continue to watch Chart 1 over the months for signs of materially tighter financial conditions. Chart 2: The Correlation Between Sovereign Risk And The Repo Rate We noted in a February Special Report that investors could use the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and Germany as a gauge of whether Chinese monetary policy has become too restrictive for its economy.1 Despite the fact that actual sovereign credit risk in China is extremely low, Chart 2 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.2 For now the correlation remains negative (as it was when we published our February report), meaning that it currently supports our earlier conclusion that monetary conditions are not overly restrictive and that financial conditions more generally are not tightening sharply (despite the recent rise in corporate bond yields). Chart 2No Sign Yet That Monetary Policy Is Overly Restrictive Chart 3Watch For Signs Of Fiscal Stimulus Chart 3: The Fiscal Spending Impulse Chart 3 presents the Chinese government's budgetary expenditure as an "impulse", calculated as expenditure over the past year as a percent of nominal GDP. Panel 2 shows the year-over-year change in the impulse. When compared with a similar measure for private sector credit, cyclical fluctuations in China's government spending impulse are relatively small. For this reason, BCA's China Investment Strategy service has not strongly emphasized fiscal spending as a major driver of China's business cycle. However, we also noted in a recent report that fiscal stimulus stands out as one of the "least bad" options available to policymakers to combat a negative export shock from U.S. protectionism, were one to occur.3 The potential for broader stimulus from Chinese authorities in response to an impactful trade shock raises the interesting possibility of another economic mini cycle in China, since the economy accelerated meaningfully in response to the last episode of material fiscal & monetary easing. As such, investors should closely watch over the coming months for signs that fiscal spending is accelerating, particularly if combined with potential signs of easing monetary policy. External Demand Chart 4: Global Demand And Chinese Export Growth Chart 4For Now, Resilient Exports ##br##Are Supporting China's Economy We have noted in several recent reports that a resilient export sector remains the most favorable pillar of Chinese growth. Besides the clear risk to Chinese trade from U.S. protectionism, two other factors have the potential to negatively impact the trend in export growth. The first (and most important) of these risks is a reduction in global demand, which some investors have recently been concerned about given the decline in global manufacturing PMIs. However, Chart 4 highlights that our global PMI diffusion indicator has done an excellent job of leading the global PMI over the past few years, and has barely registered a decline over the past few months. From our perspective, the odds are good that the recent deceleration in the PMI has been caused by sudden caution (even in developed countries) over the Trump administration's protectionist actions, and does not reflect a material or long-lasting slowdown in the global economy. But we will be closely watching the PMI releases over the coming months to rule out a more painful slowdown in global demand. Importantly, we have also highlighted that stronger exports may actually presage a further slowdown in China's industrial sector if it emboldens policymakers to intensify their reform efforts over the coming year. We argued in our May 2 Weekly Report that China's reform pain threshold is positively correlated with global growth momentum,4 meaning that the external sector of China's economy may have less potential to counter weakness in the industrial sector than many investors believe. In this regard, extreme export readings (to the up and downside) should be regarded by investors as a potentially problematic development. Chart 5: The Competitiveness Impact Of A Rising RMB Chart 5 highlights the second non-protectionist risk to Chinese export growth, namely the significant appreciation in the RMB that has occurred since mid-2017. The chart shows the percentile rank of three different trade-weighted RMB indexes since 2014, and highlights that all three are between their 70th & 80th percentiles (with our BCA Export-Weighted RMB index having risen the most). Importantly, the 2015-high shown in Chart 5 represents the strongest point for the currency in over two decades, suggesting that further currency strength may exacerbate the significant deceleration in export prices that has already occurred. Chart 5A Surging RMB Could Undercut Competitiveness Housing Chart 6: Housing Sales Versus Starts We have presented a variation of Chart 6 several times over the past few months, but it is important enough that it deserves to be continually monitored by investors over the coming year. Chart 6 tells the story of China's housing market from the perspective of an investor who is primarily interested in the sector because of its implications for growth. The chart highlights that residential floor space started, our best proxy for the real contribution to growth from residential investment, has fallen significantly relative to sales since 2012-2014. This appears to have occurred because of a significant build up in housing inventories, which has since reversed materially (even though the level remains elevated). To us, this suggests that the gap between housing sales and construction that has persisted for the past several years may finally be over, suggesting that the latter may pick up durably if sales trend higher. For now sales volume remains tepid, but this will be a key chart for investors to watch over the coming year given our view that housing is a core pillar of China's business cycle. The Industrial Sector Chart 7: The BCA Li Keqiang Leading Indicator And Its Components Chart 7 presents our leading indicator for the Li Keqiang index (LKI), which we developed in a November Special Report.5 There are six components of the indicator, all of which are related to changing monetary/financial conditions, and the growth in money and credit. Chart 6Housing Construction Could Accelerate##br## If Sales Pick Up Chart 7A Downtrend In Our LKI Leading Indicator, ##br##Within A Wide Component Range The indicator is at the core of our view, and we have been presenting monthly updates of the series in our regular reports since late last year. However, Chart 7 looks at the indicator from a different perspective, by showing it within a range that identifies the weakest and strongest components at any given point in time. Two points are noteworthy from the chart: While the overall LKI indicator has been trending down since early-2017, there is currently a wide range between the components. This gap is in stark contrast to the very narrow range that prevailed from 2014-2015, when the economy slowed considerably. This could mean that some of the components of the indicator are unduly weak, which in turn could imply that the severity of the slowdown in China's industrial sector will be less intense than the overall indicator would otherwise suggest. At least one component provided a lead on the subsequent direction of the overall indicator from late-2011 to late-2012, the last time that a significant gap existed between the components. This is in contrast to the situation today, in that all of the components are currently in a downtrend (albeit with differing paces as well as magnitudes). The key point for investors from Chart 7 is that all of the components of our indicator are moving in the same direction, which suggests with high conviction that China's economy is slowing. However, the wide range among the components suggests that indicator's message about the intensity of the slowdown is less uniform than it has been in the past, meaning that investors should be sensitive to a sustained pickup in the top end of the range. Equity Market Signals Chart 8: The Beta Of Our BCA China Sector Alpha Portfolio Chart 8 revisits a unique insight that we presented in our May 16 Weekly Report.6 The chart shows the rolling 1-year beta of our BCA China Investable Sector Alpha Portfolio versus the investable benchmark alongside China's performance versus global stocks, and suggests that the former may reliably lead the latter. While we noted in the report that drawing market-wide inferences from the beta characteristics of risk-adjusted performers is a not a conventional approach, finance theory is supportive of the idea. If investors are seeking to maximize their risk-adjusted returns and are engaging in tactical allocation across sectors, then it is entirely possible that beta-adjusted sector returns reflect the risk-on/risk-off expectations of market participants. For the purposes of China-related investment strategy over the coming year, our emphasis on Chart 8 will increase markedly if we see a sharp decline in the beta of our Sector Alpha Portfolio. As we noted in our May 16 report, the model is for now sending a curiously bullish signal, which we see as partial validation of our view that investors should have a high threshold to cut exposure to China within a global equity portfolio. Chart 8Watch For A Decline In The Beta Of ##br##Our Sector Alpha Portfolio Chart 9Decelerating Earnings Growth Could##br## Undermine Investor Sentiment Chart 9: Ex-Tech Earnings Versus The Li Keqiang Index We noted above that predicting the Li Keqiang index (LKI) is at the core of our view, and Chart 9 highlights why. The chart shows that a model based on the LKI closely fits the year-over-year growth rate of Chinese investable ex-tech earnings and, crucially, provides a lead. While the chart does not suggest that an outright contraction in ex-tech earnings is in the cards over the coming year, it does show that earnings growth is about to peak. This is potentially problematic, and warrants close attention, for two reasons: First, our leading indicator for the LKI suggests that it will decelerate further over the coming year, which could push our earnings growth estimate towards or below zero. Second, the peak in earnings growth could dampen investor sentiment towards Chinese ex-tech stocks, especially since bottom up analyst estimates for 12-months forward earnings growth have recently moved higher and are currently above what is predicted by our model. Chart 10: The Alpha Of Chinese Banks By now, the narrative surrounding Chinese banks is well known among global investors. The enormous leveraging of China's non-financial corporate sector is viewed by many as a clear sign of capital misallocation, meaning that a (potentially material) portion of the loan book of Chinese banks will have to be written off as bad debt. The ultimate scope of the bad debt problem in China is far from clear, but these longstanding concerns about loan quality suggest that Chinese bank stocks are likely to materially underperform their global peers if China's shadow banking crackdown begins to pose a significant threat to growth via restrictions on the provision of credit to the real economy. As such, we recommend that investors monitor Chart 10 over the coming year, which shows the rolling 1-year alpha significance for Chinese banks vs their global peers. While the rolling 1-year alpha of small banks has become less positive over the past few weeks, it remains in positive territory, similar to that of investable bank stocks. So, for now, this indicator supports our earlier conclusion that recent divergence between the interbank market and actual borrowing rates highlighted in Chart 1 is not heralding a material tightening in Chinese financial conditions. Chart 10Investors Should Monitor Chinese Bank Alpha ##br##For Significant Declines Chart 11No Technical Breakdown (Yet) In Ex-Tech Relative Performance Chart 11: The Technical Performance Of Ex-Tech Stocks BCA's approach to forecasting financial markets rests far more on top-down macroeconomic assessments than it does on technical analysis. However, technical indicators do contain important information, particularly when our top-down macro approach signals that a change in trend may be imminent. In this regard, technical indicators can provide valuable opportunities to enter or exit a position. To the extent that the technical profile of Chinese ex-tech stocks is informative in the current environment, Chart 11 shows that it is telling investors to stay invested despite the myriad risks to the economic outlook. This message is consistent with that of Table 1, namely that the negative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. From our perspective, a technical breakdown in relative Chinese ex-tech stock performance in response to China-specific news would serve as a strong basis for a downgrade within a global equity portfolio, and we will be monitoring closely for such a development over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Question That Won't Go Away", dated April 18, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 6 Please see China Investment Strategy Weekly Report, "The Three Pillars Of China's Economy", dated May 16, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Chart 7...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Chart 12...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Chart 8Sovereigns Still##br## Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The prospects for U.S. economic and earnings growth remain solid but overseas growth is rolling over. The U.S. economic surprise index is poised to turn negative but inflation surprise is headed the in the opposite direction. The Fed remains vigilant on financial stability issues. The minutes of the May FOMC meeting provided an update on the Fed's views of inflation, fiscal and trade policy. In addition, financial stability and the Fed's forward guidance were discussed. Feature Economic data released in recent weeks reinforce BCA's view that the U.S. economy is accelerating while the global economy is decelerating. Chart 1 (panel 1) shows that the index of leading economic indicators (LEI) is gaining strength in the U.S., but slowing in the rest of the developed economies (panels 2 through 6). However, the U.S. Purchasing Managers Index (PMI, solid line) is rolling over, along with the PMIs in the E.U., Japan, Canada and Australia, albeit from a high level. Still, the Treasury and currency markets are focused on the LEIs and not the PMIs, driving up both Treasury bond yields and the dollar (Chart 2). Chart 1U.S. Growth##BR##Stands Out Chart 2Treasury Yields And The Dollar##BR##Responding To Growth Differentials The fallout from political turmoil last week in both North Korea and Italy spilled over into U.S. financial markets, driving U.S. risk assets and Treasury yields lower. Of the two, the situation in Italy is the more significant threat to our view that the U.S. stock-to-bond ratio will continue to move higher this year. BCA's Global Fixed Income Strategy service notes that while investors are right to be worried about a new populist government in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns.1 Our Geopolitical Strategy service's baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals.2 However, this will first require the pain of higher bond yields. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic growth outpaces its global counterpart.3 BCA's U.S. Bond Strategy service maintains that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. In addition, spread product returns should continue to beat Treasuries, but the window for outperformance is closing.4 Investors' positioning in Treasuries and our view that the Citigroup Economic Surprise Index (CESI) may soon drop below zero,5 suggest that there is a near-term risk of a countertrend rally in Treasury prices. Assessing The Cycle BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 as it finds itself behind the curve on inflation. Chart 3 shows that the odds of a recession in the next 12 months are low. Moreover, the traditional recession signals we track are not flashing red (Chart 4). At 45 bps, the 10/2 Treasury curve remains positive (panel 2). BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5%. We anticipate that upward pressure on the short end from Fed rate hikes will be offset by the upward thrust of the breakevens on the long end.6 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The April LEI rose by 6.42% year-over-year. Initial claims for unemployment insurance in the week ending May 18 were 17K below their mid-November 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. Chart 3Odds Of A Recession Remain Low Chart 4No Recession Signals Here Credit spreads also indicate that the economic expansion remains in place. Charts 5 and 6 show that the corporate bond market often warns of an approaching major top in the stock market and/or a recession. Spreads barely budged during February's spike in financial market volatility. Chart 5Credit Spreads On Both Investment Grade... Chart 6... And High Yield Debt Signal That The Expansion Has Legs Financial conditions remain supportive of above-potential growth in the final three quarters of 2018. The January peak in equity markets and troughs in investment- grade and high-yield spreads marked the recent zenith in BCA's Financial Conditions Index (FCI). Nonetheless, the FCI in the U.S. remains more expansionary than it was a year ago and our research7 shows that financial conditions lead the U.S. economy by six to nine months (Chart 7). As a result, U.S. economic growth is poised to accelerate even more in 2018. This will further push down the unemployment rate below NAIRU and ultimately force up wage and price inflation. Chart 7Lagged Effect Of Easier Monetary##BR##Conditions Will Boost Growth Bottom Line: The prospects for U.S. economic and earnings growth remain solid, aided by the lagged effect of easy financial conditions, the ongoing benefits of the 2017 Tax Cut and Jobs Act and other doses of fiscal stimulus enacted in the past six months. Moreover, several of the geopolitical risks that we flagged earlier this year have ebbed. However, as noted above, the political situation in Italy warrants investors' attention. Nonetheless, the period of synchronous global growth that lifted risk assets in 2017 and in early 2018 has ended. Chinese growth is slowing, and other emerging market economies and financial markets are under duress as U.S. rates escalate. Moreover, the U.S. economy is in the late part of the cycle. Lofty valuations implied that equity returns will be well below-average in the next five to seven years. Stay overweight stocks versus bonds for now. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Surprise Surprise Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 8) after hitting a four-year high, 110 days ago, in late 2017. Since then, a colder and wetter winter and early spring across the U.S., coupled with elevated expectations after the tax bill, saw most economic data fall short of expectations. Chart 8Economic Surprise Poised To Move Lower Our late March 2018 report8 noted that since 2011, there were six other episodes when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, we stated in our March 2018 report that a trough in the Citigroup Economic Surprise reading may be a month or two away. Based on BCA's research,9 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. On the other hand, the inflation surprise index is about to turn positive for the first time since 2011. Chart 9 shows that the last time reports on the CPI, PPI and average hourly earnings consistently exceeded consensus forecasts was in late 2009 and early 2010. Moreover, from the last few years of the 2001-2007 economic expansion through to early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Typically these periods when inflation surprise is positive are associated with higher wage and compensation metrics and higher realized core inflation. Moreover, Chart 9 shows that sustained episodes where the inflation surprise index is above zero occurred when the economy was at full employment (panel 2) and when the Fed funds rate was above neutral (panel 3). The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to raise rates gradually at first, but then more aggressively starting in mid-2019. Nonetheless, inflation due to cyclical factors remains muted for now. Chart 10 shows that pro-cyclical inflation decelerated through March 2018, while acyclical inflation accelerated. Late last year we discussed this measure of inflation and its origins at the San Francisco Fed.10 Chart 9Inflation Surprise Vs.##BR##Realized Inflation And Slack Chart 10Noncyclical Sources Still##BR##Driving Inflation Lower Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI turns negative. However, the weakness in the economic data does not signal recession. We expect that the inflation surprise index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. On The MOVE Both equity and bond market volatility (measured by the VIX and the MOVE indexes respectively) climbed in late January and early February, but have since eased (Chart 11). However, in the past 9 weeks, bond volatility surged relative to equity vol. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks. The implication is that bond-to-stock volatility ratio will move higher. Periods when bond volatility is rising faster than equity volatility are associated with turning points in the stock-to-bond ratio, and both real and nominal Treasury yields (Chart 12). That said, we are not making the case that the current upward thrust of the stock-to-bond ratio is about to change direction. Since 1990, both the stock-to-bond ratio and real bond yields rose in six of the eight periods when the MOVE/VIX rose; nominal yields climbed in all but one of these episodes. Moreover, small cap equities tend to outperform large when the MOVE index is increasing faster than the VIX. Chart 11Equity Vol Vs. Bond Market Vol Chart 12Is The MOVE/VIX Ratio On The Rise Again? Bottom Line: The increase in both equity and bond market volatility will impact the way the Fed conducts monetary policy in the coming years. Financial stability, or the lack thereof, is now top of mind among policymakers, and even more so as policy turns restrictive. The Fed's Third Mandate Revisited Chart 13FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate11 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the May meeting by both Fed staff and voting FOMC members, but it was not on the agenda at March's meeting. Nonetheless, we expect Fed Chair Jay Powell to follow the former chair's lead on this issue. At the May meeting, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance. This overall assessment incorporated the staff's judgment that asset valuations remain elevated. Fed staff appraised vulnerabilities as low from financial sector leverage and maturity and liquidity transformation, low-to-moderate from household leverage, and elevated from leverage in the non-financial business sector (Chart 13). In May the Fed also provided an assessment of foreign financial stability for the first time since November 2017. The central bank's economists and analysts characterized overall vulnerabilities to foreign financial stability as moderate while highlighting specific issues in some foreign economies, including elevated asset valuation pressures, high private or sovereign debt burdens and political uncertainties. Fed staff made the same assessment in November 2017. In a report last month we highlighted research from the Federal Reserve Bank of San Francisco which found that a more restrictive monetary policy could pose risks to financial stability.12 Bottom Line: The Fed will remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses if policy stays too loose for too long. Counting The Minutes Inflation appeared to be a key topic at the May 1-2 Federal Open Market Committee (FOMC) meeting.13 Moreover, at least a few members indicated that the Fed is willing to tolerate inflation above the central bank's 2% target. Trade and fiscal policy, the labor market, financial stability, the yield curve and the Fed's communication plan were also discussed. Fed economists recently updated their quantitative assessments of the FOMC's minutes.14 The note provides a guide (Table 1 in the Fed paper and Table 1) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 1FOMC Minutes Rubric Tables 2 and 3 evaluate the Fed's latest thinking on inflation and its outlook. Most FOMC participants viewed the recent firming in inflation as reassurance that inflation is on track to hit the central bank's 2% target, while some thought inflation may overshoot. Several opined that the underlying inflation trend had changed little (Table 2). There was wide disagreement on the inflation outlook. Table 3 shows that many participants agreed that the Fed's goal was to return inflation to the 2% target. Many participants cited the tight labor and product markets, and stable inflation expectations, to support their views that inflation would remain near 2% this year. This approach is in line with BCA's inflation stance. A few participants worried about the impact of higher oil prices on inflation, but a similar number expressed concern that inflation would not stay at the Fed's 2% goal. Table 2FOMC Assessment Of Current Inflation Table 3FOMC Assessment Of Inflation Outlook There were extensive comments from both Fed staff and FOMC participants about the impact of fiscal policy and trade on the economy and inflation. Chart 14 presents the IMF's estimate of the impact of fiscal policy on the U.S. economy in the next few years. Fed staff continued to assume that the tax cuts would boost real GDP growth moderately in the medium term, but noted that fiscal policy may not provide a boost to growth if the economy is operating above full employment. Several FOMC participants noted the challenges in assessing the influence of fiscal policy on both the demand and supply side of the economy. We discussed the impact of fiscal policy on the supply side in last week's report.15 Chart 14U.S. Fiscal Stimulus Will##BR##Support Growth In '18 And '19 On trade, some FOMC participants noted that there was a wide range of outcomes for economic activity and inflation depending on what actions were taken by the U.S. and how U.S. trading partners responded. A few noted that the uncertainty around trade could dampen business sentiment and spending. In a recent report,16 we stated that the Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition. The FOMC also discussed factors contributing to the flat yield curve, citing the expected gradual rise of the federal funds rate, the downward pressure on term premiums from the Fed's still-large balance sheet as well as asset purchase programs by other central banks, and a reduction in investors' estimates of the longer-run neutral real interest rate. Notably, only a handful of participants said that the curve was not a reliable signal of future economic activity, while several endorsed the idea that an inverted curve indicated an increased risk of recession. On financial stability, a couple of participants noted that after the bout of financial market volatility in early February, the use of investment strategies predicated on a low-volatility environment may have become less prevalent, and that some investors are more cautious. However, they also noted that asset valuations across a range of markets and leverage in the nonfinancial corporate sector remained elevated relative to historical norms, leaving some borrowers vulnerable to unexpected negative shocks. Several noted that regulatory reform since the crisis had contributed to stronger capital positions, while only a few emphasized the need to build additional buffers in the financial system. The key takeaway from the FOMC's discussion on its communication policy is that the Fed may soon alter the forward guidance in its post-meeting statement to acknowledge that policy will not remain accommodative indefinitely. Bottom Line: The minutes of the May FOMC meeting indicate that the Fed is gearing up to raise rates again next month, but it is not signaling a more hawkish path than what is discounted. At the same time, the Fed is not trying to drive market expectations for the future path of short-term interest rates sharply higher. Fed officials noted that a temporary overshoot of the 2% inflation target would not be a disaster. In other words, the Fed is not willing to deviate from its path of "gradual" rate hikes. This is defined as one 25bps rate hike per quarter, which is mostly in line with current market pricing. We maintain our base case scenario: the FOMC will continue to monitor financial stability under Powell and raise rates four times in 2018. However, the FOMC will have to become more aggressive when realized inflation climbs and inflation expectations approach 2.3 to 2.5%. At that point another vol shock is likely, given that the Fed would target slower growth to curb inflation. This would be a negative signal for risk assets. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny or Mostly Cloudy?", published May 22, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Italy: Growth Cures All Ills...For Now", February 21, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Swan Song", published May 18, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", published October 31, 2017. Available at usbs.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics", published April 17, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear", published October 4, 2017. Available at gfis.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...", published March 26, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "Solid Start", published January 8, 2018 and "The Revenge Of Animal Spirits", published October 30, 2017. Both available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "2018: Synchronized Global Growth: Drives U.S. Economy And Markets", published December 4, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", published July 24, 2017. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short-Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com. 13 https://www.federalreserve.gov/monetarypolicy/fomcminutes20180502.htm 14 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 15 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Too Soon For Stagflation?", published May 21, 2018. Available at usis.bcaresearch.com. 16 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors", published May 7, 2018. Available at usis.bcaresearch.com.
Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights China's industrial sector will continue decelerating, while consumer spending is so far booming. The world economy in general and EM in particular are exposed much more to China's industrial sector than to its consumer spending. The U.S. dollar will continue strengthening, regardless of the trend in U.S. bond yields. The reason is slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. Stay put on / underweight EM financial markets. Turkey will need to hike interest rates more before a buying opportunity in its financial markets emerges. Feature The two key elements affecting the performance of EM financial markets are the U.S. dollar and commodities prices. The combination of a weak U.S. dollar and higher commodities prices is typically bullish for EM. The opposite also holds true: A strong dollar and lower commodities prices are bearish for EM. But what about the recent dynamics - the rally in the greenback and strong commodities prices? This combination is unlikely to be sustained. Historically, the divergence between the dollar's exchange rate and commodities prices has never lasted long (Chart I-1). The fundamental linkage between the U.S. dollar and commodities prices is global growth: improving global growth is positive for resource prices, and the U.S. currency has historically been negatively correlated with global trade - the trade-weighted dollar is shown inverted in this chart (Chart I-2). Chart I-1Commodities And The Dollar Chart I-2Global Growth And The Dollar Hence, if global growth stays strong, the U.S. dollar will pare its recent gains and commodities prices will stay well-bid. Conversely, if global trade decelerates commodities prices will inevitably have to change direction. We expect the dollar to stay well-bid because the current phase of dollar rally will at some point be followed by a second phase where the greenback's strength is driven by a slowdown in global trade. In this phase, commodities prices and U.S. bond yields will drop alongside a strengthening U.S. dollar. Weaker growth in China and in other EMs is the key reason we expect global trade volumes to slow. Is China Slowing? Making sense of growth conditions in China is never easy, but it is particularly confusing these days. We maintain that there is growing evidence that China's industrial segment is slowing and will continue doing so, yet consumer spending is still booming. The basis for the industrial slowdown is a deceleration in both money and credit growth, which has been taking place over the past 18 months or so. With respect to households, the borrowing binge continues. The unrelenting 20%+ annual growth in household credit continues to fuel the property bubble. In turn, a rising wealth effect from real estate as well as decent income growth are the underpinnings behind the booming consumer sector. The main and relevant point for investors from the perspective of China's impact on broader EM is as follows: the drop in the credit and fiscal impulse is heralding a deceleration in capital expenditures/construction. That, in turn, will lead to fewer imports of commodities and materials. Imports are the main transmission mechanism from China's economy to the rest of the world. Mainland imports in RMB terms have indeed decelerated meaningfully, yet import values in U.S. dollar terms have not (Chart I-3). So, what explains the recent gap between imports in yuan and dollar terms? The RMB's rally versus the U.S. dollar in the past 15 months has been responsible for this gap between import values. As one would expect, the spending power of mainland industrial companies has moderated because less credit and fiscal expenditures are being injected into the system (Chart I-4). Yet because the RMB now buys 10% more U.S. dollars than it did a year ago, mainland buyers' purchasing power of foreign goods that are priced in dollars has improved. As a result, the pace of growth of the value of U.S. dollar imports has remained buoyant. Chart I-3Chinese Imports In RMB & USD Terms Chart I-4Weaker Purchasing Power ##br##In China Will Hurt Imports If the RMB's exchange rate versus the dollar remains flat over the next 12 months, the growth rates of both imports in RMB and dollar terms will converge. In this case, a further slowdown in import spending in RMB terms will translate into considerable deceleration in mainland imports in U.S. dollar terms. In brief, the exchange rate is important because the U.S. dollar's depreciation versus the RMB since January 2017 has prevented the spillover from a slowdown in China's imports in local currency terms to the rest of the world in general and EM in particular. Chart I-5Goods And Services Imports: China And U.S. If and as the dollar continues to rally versus the majority of currencies, China could allow its currency to slip versus the greenback to assure a flat trade-weighted exchange rate and preserve its competitiveness. In such a scenario, China's purchasing power of goods and services from the rest of world will be impaired - which in turn means this economy will be remitting fewer dollars to the rest of the world. This will reduce the flow of U.S. dollars from China to EMs, adversely impacting the latter's financial markets and economies. Chart I-5 illustrates that China's imports of goods and services amount to $2.3 trillion compared with U.S. imports of goods and services of $3.1 trillion. Therefore, in terms of importance in global imports, China is not too far behind America. This holds true with respect to remitting dollars to the rest of the world. Provided that China imports more from EM - both from Asian manufacturing economies and commodities producers - than the U.S. does, then less mainland imports will entail fewer dollars flowing to EM. In short, the continued slowdown in China's purchasing power in U.S. dollar terms will negatively affect the rest of EM. This rests on our baseline view that mainland credit growth will continue slowing and the RMB will weaken against the dollar, albeit modestly for now. Mirroring the divergence between industrial sectors and consumers in the Middle Kingdom, there has been an equally clear divergence within imports: Imports of industrial supplies excluding machinery have slumped, while imports of household goods have continued to flourish. Chart I-6 demonstrates that imports have decelerated for base metals, chemicals, wood, mineral products and rubber. Even oil and petroleum products imports have slowed (Chart I-7). Yet imports of consumer goods are roaring (Chart I-8). Chart I-6China: Industrial Imports Are Slowing Chart I-7Chinese Fuel Imports Are Slowing Chart I-8Chinese Consumer Goods Imports Are Robust Which one is more important for EM: the industrial sector or consumer spending? Many developing economies in Latin America, Africa, the Middle East as well as countries such as Russia, Indonesia and Malaysia are very dependent on their commodities exports. These economies do not benefit much from booming Chinese consumers. For them, the critical variable is the mainland's industrial sector and its absorption of minerals and resources. In terms of size, Table I-1 illustrates that non-food commodities, industrial goods, machinery, equipment and transportation make up overwhelming majority of China's total imports. Meanwhile, consumer goods imports, excluding autos, comprise 15% of total imports. Hence, their impact on the rest of the world is small. Table I-1Structure Of Chinese Imports Further, most of consumer goods that households in China consume are produced locally rather than imported. That is why the world economy at large and EM in particular are more exposed to the mainland's industrial sector than its consumer one. Aside from imports, there are several other variables that validate our thesis of an ongoing slowdown in China's industrial sector. In particular: Total floor space sold (residential plus non-residential) has rolled over, heralding weakness in floor space started and, eventually, construction activity (Chart I-9). Growth rates of total freight traffic, diesel consumption, electricity and plate glass output have slumped (Chart I-10). Chart I-9Slowdown In Chinese Real Estate Chart I-10China: Industrial Economy Is Weakening Nominal manufacturing production is decelerating in response to a weaker broad money impulse (Chart I-11). The Komatsu Komtrax index - which measures average hours of machine use per unit of construction equipment (excluding mining equipment) - has begun contracting (Chart I-12). Chart I-11China: Downside Risks In Manufacturing Chart I-12China: Sign Of Construction Slump Even though China's spending on tech products has been vibrant, the global semiconductor cycle - a harbinger of overall tech industry growth - is clearly downshifting as evidenced by declining semiconductor prices (Chart I-13). Finally, narrow money (M1) growth has historically correlated with Chinese H-share prices, and is currently pointing to considerable downside risk for Chinese equity prices (Chart I-14). Chart I-13Semiconductor Prices Are Falling Chart I-14Chinese Share Prices Are At Risk Bottom Line: China's industrial sector has been decelerating, a trend that will persist. Meanwhile, consumer spending is so far booming. The former is more important to the rest of the world in general and EM in particular than the latter. EM Selloff: Two Phases While it is impossible to forecast the timing and character of market dynamics and mini-cycles with precision, our assessment is that two phases of an EM selloff are likely. Phase 1: A relapse in EM financial markets occurs on the back of rising U.S. bond yields, a strong dollar, amid resilient commodities prices. This phase is currently underway. Phase 2: U.S. bond yields peter out and drift lower, yet the U.S. dollar continues to firm up, commodities prices relapse and the EM selloff progresses. This stage has not yet commenced. The driving force behind these dynamics would be slower global demand growth emanating from China and spreading to other developing countries. In between Phases 1 and 2, it is possible that EM will stage a temporary rebound. Yet the duration and magnitude of such a rebound are impossible to gauge. Because of its transient nature, barring precise timing, the rebound will be very difficult to play profitably. It is not impossible to envision that the escalating turmoil in EM financial markets could at some point lead the Federal Reserve to sound less hawkish. That could mark a top in U.S. bond yields. In such a scenario, will a peak in U.S. bond yields mark a bottom in EM currencies? It may do so temporarily, but the sustainability of a rally in EM currencies and risk assets would be contingent on global growth in general and commodities prices in particular. Chart I-15An Unsustainable Rebound ##br##In EM Stocks In 2014 As a matter of fact, a similar two-phase selloff with a rebound in between occurred in 2013-'15. Chart I-15 illustrates that EM currencies and stocks staged a short-lived rebound after U.S. bond yields peaked in late 2013. Yet this rally proved transient. The underlying impetus behind the resumption in the EM downtrend back in 2014-'15 was weakening growth in China, falling commodities prices and poor domestic fundamentals. Similar to the 2013-'15 episode, any rebound in EM risk assets resulting from lower U.S. bond yields will likely be fleeting if commodities prices drop, the dollar continues to firm up and global growth disappoints. To sum up, a potential rollover in U.S. bond yields in the coming months will not automatically entail an ultimate bottom in EM risk assets. Trends in global growth - particularly in China - and commodities prices will be critical to the outlook for EM. As per our themes and discussion above, we maintain that China's industrial growth and construction will surprise on the downside. Consequently, China's commodities imports will moderate, which will weigh on commodities prices. In the interim, weak global trade dynamics stemming from EM/China will benefit the dollar, which is a countercyclical currency. Bottom Line: The U.S. dollar will continue strengthening regardless of the trend in U.S. bond yields because of slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. EM financial markets will remain under selling pressure as long as global growth continues slowing. EM Foreign Funding Vulnerability Ranking Which countries are most exposed to lower foreign funding? Chart I-16 presents ranking of EM countries based on foreign funding requirements. The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-16Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. Mostly, these stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen. The basis for this is depreciating currencies will make their foreign debt liabilities more expensive to service. Besides, as these debtors allocate more resources to service foreign debt, their spending will be negatively impacted and their domestic economies will weaken. Investment Conclusions Chart I-17Downside Risks In EM Share prices The dollar's strength will be lasting. Stay short a basket of select currencies such as the BRL, TRY, ZAR, CLP, IDR, KRW and MYR versus the U.S. dollar. For portfolios that need to overweight some EM currencies relative to the rest, our favorites are MXN, RUB, PLN, CZK, TWD, THB and SGD. CNY will for now modestly weaken versus the dollar but outperform many other EM peers. The biggest risk to the U.S. dollar in our opinion is the Trump administration's preference for a weaker greenback. Therefore, "open-mouth" operations by the U.S. administration to weaken the dollar are possible, and the dollar could experience temporary setbacks. Yet the path of least resistance for the dollar remains up, for now. There is considerable downside in EM share prices. Stay put and underweight EM versus DM in general and the S&P 500 in particular. Chart I-17 illustrates that rising EM sovereign bond yields and U.S. corporate bond yields (both shown inverted on the chart) herald a further selloff in EM stocks. Our equity overweights are Taiwan, Korea, Thailand, India, central Europe, Chile and Mexico, and our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. For fixed-income investors, defensive positioning is warranted. As EM currencies continue to depreciate, sovereign and corporate credit spreads will widen further. Credit portfolios should continue underweighting EM sovereign and corporate credit relative U.S./DM corporate credit. Foreign holdings of EM local currency bonds remain massive. EM currency depreciation versus DM currencies will erode returns for foreign investors and could spur some bond selling, exerting upward pressure on local yields as well.1 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Is The Worst Over? After having dropped 30% in U.S. dollar terms since their peak in late January, Turkish equity prices are beginning to look depressed, begging the question whether a buying opportunity is in the cards. Our assessment is as follows: the nation's financial markets are not yet at the point to warrant an upgrade (Chart II-1). Judgment on Turkish markets is contingent on three questions: Has the lira become cheap? Are real interest rates sufficiently high to depress domestic demand and reduce inflationary pressures? Are equity valuations cheap enough to warrant buying despite the poor cyclical profit outlook? First, the lira needs to get cheaper. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of May 23 the lira is one standard deviations below its historical mean (Chart II-2). For it to reach one-and-half or two standard deviations below its fair value, it would roughly take another 10%-20% depreciation, versus an equal-weighted basket of the dollar and euro. Chart II-1Turkish Financial Markets ##br##Have More Downside Chart II-2The Turkish Lira Is Not That Cheap Second, in regard to monetary policy, our view is that it would take an increase of around 200-250bps in the policy rate in addition to yesterday's hike of 300bps to stabilize financial markets. Core inflation will likely rise to at least 14-15% from the current level of 12% in response to the ongoing currency depreciation. With the effective policy rate (the late liquidity window rate) now at 16.5%, another 200-250 basis points hike would push the nominal rates to 18.5-19% and real policy rate to 3.5-4%, a minimum level that is likely required to depress excessive domestic demand growth. Finally, equity valuations are reasonably appealing but not cheap enough to put a floor under share prices given the outlook for contracting corporate and bank profits. Chart II-3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now about 6, compared with the historical average of 8. Although this bourse is already one standard deviation cheap, the outlook for profit recession likely warrants even lower valuation to justify buying. Chart II-3Turkish Equities Could Get Cheaper An approximate 20% drop in share prices in local currency terms will bring the CAPE to 4.8, one-and-half standard deviation below the fair value. On the whole, an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms will likely create a buying opportunity in Turkish financial markets. That said, it is doubtful whether there is the political will - to tolerate another 15% drop in the currency from current levels or more tightening in monetary conditions in the very near run ahead of the upcoming June parliamentary elections. Given the authorities' tolerance for higher borrowing costs is low, investors should not rule out the potential for capital controls to be imposed. In fact, to protect assets against possible capital control, we would recommend investors who are short to consider booking profits if the exchange rate surpasses 5 USDTRY in a rapid manner. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD Non-dedicated long-only investors should for now stay clear of Turkish financial markets. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we continue recommending underweight positions in Turkey. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 We discussed EM currencies and bonds in details in May 10, 2018; the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations