Economy
Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Investors' justification for owning stocks has shifted from TINA - There Is No Alternative, to LISA - Let's Invest Somewhere, Anywhere. Long-term earnings expectations have broken out, suggesting that investors have greatly improved confidence about the health and longevity of the business cycle. Economic conditions are improving, but equity prices have overshot. The recent tightening in monetary conditions means that a payback period is ahead. OPEC has put a floor under oil prices; we expect WTI oil prices to average $55/bbl in 2017. Feature Equity market behavior since early November has been both incredible and incredulous. Instead of dropping spectacularly, as most pundits forecast ahead of a Trump win, the S&P 500 has gained 5.2% since November 8. The rally has occurred on the back of a modest improvement in recent economic data, and a lot on the back of hope. As we outlined in our November 21 report,1 there are as many market-negative proposals in Trump's plans as there are equity market-friendly ones. Indeed, it is incredulous that prices have rallied on so little good news. Not only have prices rallied, but there appears to be a fundamental shift in investors' expectations about long-term earnings prospects. Chart 1 shows five-year earnings for S&P 500 companies. Expectations have broken out of the low range that has reigned since the beginning of the Great Recession. It appears that investors' justification for owning stocks has shifted from TINA (There Is No Alternative) to LISA (Let's Invest Somewhere, Anywhere). Chart 1Sudden Optimism In The Long-Term Outlook! From 2010 until last year when the Fed started raising interest rates, "There Is No Alternative," or TINA, was the adage that best described the behavior of investors in a ZIRP/QE world, where cash earned nothing and there was a shortage of risk-free bonds. As central banks across the globe initiated quantitative easing by buying the safest assets and compressing their yields, investors were forced further out on the risk spectrum. This portfolio balance effect from QE first bid up non-Treasury fixed income products and then spilled over to fixed income equity proxies, such as REITs and higher dividend stocks. For instance, the S&P Dividend Aristocrats index, an aggregate of stable dividend-growing stocks, historically only ever outperformed the S&P 500 in recessions, when investors prefer to hide in relatively high-quality companies that consistently grow their dividends (Chart 2). But during this cycle, Dividend Aristocrats have handily outperformed the S&P 500 each year since 2009, as the index was an important TINA beneficiary. Now that the Fed is finally finding its groove in a new rate cycle (please see the section on page 5), cash is no longer earning zero (albeit it is still not particularly appealing), and Treasury yields are finally comfortably off their multi-decade lows. In other words, investors are beginning to once again have alternatives. Does this mean that investors are giving up on TINA? We think so, but what comes next is difficult to gauge. We have long argued that ending the dance with TINA would require one of two scenarios: 1) A drastic economic shock such as a recession that sends investors into cash and other safe havens, or 2) A significant change in the price of bonds that makes dividend yielding equities less attractive. The former is very unlikely given that a non-inflationary backdrop means that the Fed will not need to raise interest rates at a pace that will meaningfully impact growth. The second scenario is now underway, although the sustainability and magnitude of this trend is unclear. As we highlighted last week, bond yields have shot to undervalued territory, based on our indicators and assumptions about growth over the next year. True, it is encouraging that economic indicators have perked up in recent weeks. In particular, it is positive that there has been a noticeable uptick in consumer confidence over the past couple of months, particularly as job security is improving. Chart 3 summarizes a wide range of economic indicators that are showing recent strength: Global LEI, core PCE inflation, and the Global Manufacturing PMI are among those that have increased. Still, as the chart highlights, these improvements remain subdued and in some cases, recent data points have been too choppy to give a reliable signal. The ISM manufacturing survey is a case in point. Meanwhile, the ISM non-manufacturing survey headline index has jumped higher, as did the employment index. However, the forward-looking component, new orders, dropped. Chart 2TINA Pushed Investors##br## Into Yield Chart 3Momentum Strong Enough ##br##To Bid Up Equity Prices? This economic performance is at odds with the investor optimism captured in Chart 1: there is considerable discrepancy between market expectations and economic data. Granted, financial markets tend to be forward-looking, but the current message is that investors have drastically changed their view about the trajectory of growth and earnings. We do expect economic growth to improve in 2017, as consumers begin to spend more of their wage gains than over the past five years. But the headwinds to profit growth, notably a weak pricing backdrop, and a strong currency are still in place. We believe that market moves and investor sentiment has moved too far, too fast. This swing to optimism appears to be ushered in by LISA, Let's Invest Somewhere, Anywhere. With LISA, investors have traded in their forced justifications (i.e. the lack of alternatives) for unfounded ones (drastically improved long-term earnings outlook). In this environment, the likelihood of profit disappointments runs high. For now, LISA's disregard for fundamentals can prop up equity prices, but with monetary conditions tightening via a simultaneous rise in the dollar and bond yields, investor optimism is likely to be curtailed. Indeed, if bond investors begin to forecast the same rosy growth scenario as equity investors, then there is a danger that an overly aggressive re-pricing of the Fed rate path transpires (Chart 4). This after years of bond market expectations remaining lower than the Fed's dot-plot projections. Chart 4Bond Market Risk: From Underpricing To Overpricing The Fed? Fed Preview Bond market expectations for a rate hike on Wednesday are nearing 100%, which is consistent with our expectations. The Fed will raise interest rates and the only uncertainty is the extent of hawkishness in the accompanying FOMC statement and post-meeting press conference. Chart 5Inflation And Stimulus: Canadian Case Study At this point in the economic cycle, the pace of future rate hikes will depend much more on the Fed's outlook for inflation than for the labor market. As we wrote in a Special Report on November 28,2 the labor market is likely now nearing full employment, i.e. is tight enough to create modest upward pressure on wages. In other words, the Fed's objective of full employment has been - or is at least very close to - being met. Nonetheless, we are not worried about an imminent aggressive turn higher in inflation. True, if our economic forecast for next year pans out, then growth will run somewhat hotter than underlying trend growth (estimated by the Fed to be at 1.8%). That said, there are several headwinds that will keep inflation contained: The U.S. continues to import deflation from overseas. About one-third of the core PCE basket is core goods and prices continue to deflate. Recall that in the early 2000s business cycle recovery, even with a falling U.S. dollar, goods prices could not escape deflation. Retail prices, which represent about 30% of the total core PCE index, continue to deflate at a faster rate than at any point in the past fifteen years. Bond market inflation expectations have surged on the expected inflationary impact of Trump's political agenda. We concede that aggressive fiscal spending and larger budget deficits have the potential to spur inflation, but this is not yet a foregone conclusion. Investors looking for a roadmap for the impact of fiscal spending may turn to Canada. The Trudeau government was elected in October 2015 on a platform of fiscal spending and middle-income family tax cuts. According to the Bank of Canada this week, "the effects of federal infrastructure spending are not yet evident in the GDP data... business investment and non-energy goods exports continue to disappoint". Fourteen months after the election, inflation is still at 2% (Chart 5). A final point is that multiple statistical models refute the notion that a sustainable breach of the 2% inflation target is imminent. Last month, the Cleveland Fed published a report that showed that 5 out of 6 of the top Fed inflation models assign a less than 50% probability to inflation's being 2% or higher over the next three years!3 Our takeaway from their research is a reminder that even once the output gap closes, it can take a long time for inflation pressures to build and for inflation expectations to move higher. The bottom line is that it is too early to expect a shift in the message from the Fed. After the December rate hike, the Fed will maintain its policy of responding to incoming data. We expect minimal revisions to the Fed's economic and inflation forecasts and therefore to their expected rate path. An Update On Oil Two weeks ago, OPEC members agreed to cut 1.2 million barrels of its daily oil output, starting in January. After the initial knee-jerk reaction to a potentially tighter oil market next year (oil prices jumped 10%), prices have started to reverse. Doubts about OPEC's ability to stick to the quota are beginning to set in. According to a Reuters poll,4 most analysts expect cheating, and have doubts about whether quota cuts will be enough to rebalance markets. Our commodity strategists believe that OPEC will by and large respect the new quotas, primarily because both Russia and Saudi Arabia need higher prices. Both countries have consumed considerable foreign reserves to fund government expenditures following the price collapse. BCA estimates that Saudi Arabia will have burned through $220 billion in reserves between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, equivalent to 30% of foreign reserves. Russia will have drawn down its official reserves by $77 billion over the same period, or 16% of its total holdings. Our commodity team expects to see evidence of the cuts begin to show up in February-March, in the form of falling commercial inventory levels. Even if actual cuts only amount to 60-70% of the volumes agreed at OPEC's November 30 meeting, OECD storage levels - combined commercial inventories of both crude oil and refined products - could fall by 10%, i.e. to about 2.75 billion barrels by the end of 2017Q3. This would put stocks roughly at their five-year average levels, the stated goal of OPEC, and its reason for negotiating the production cut (Chart 6). Chart 6Oil Inventories Normalizing Chart 7OPEC Putting A Floor At /bbl For WTI In sum, we believe that the OPEC agreement will at the very least put a floor under oil prices at around $45/bbl for WTI (Chart 7). We expect prices to average at $55/bbl in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com David Boucher, Editor/Strategist U.S. Investment Strategy davidb@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten," dated November 21, 2016, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com. 3 "The Likelihood of 2 Percent Inflation in the Next Three Years," Federal Reserve Bank Of Cleveland, November 29, 2016. 4 Please see "OPEC expected to deliver only half of target production cut: Kemp," published online by reuters.com on December 6, 2016. OPEC has invited Russia, Colombia, Congo, Egypt, Kazakhstan, Mexico, Oman, Trinidad and Tobago, Turkmenistan, Uzbekistan, Bolivia, Azerbaijan, Bahrain and Brunei to meet in Vienna Dec. 10, according to Reuters.
Highlights Investors are understating the risks that the Trump administration will enact protectionist trade policies. Contrary to popular belief, the economic costs to the U.S. of a protracted "trade war" would be low. The geopolitical impact, however, would be much more sizeable, as would the impact on S&P 500 profits. The near-term risks to global equities are on the downside, although firmer growth in developed economies should provide support to stocks over a 12-month horizon. Global bond yields will be higher this time next year, as will the dollar. The yen is especially vulnerable. We are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. Feature They come over here, they sell their cars, their VCRs. They knock the hell out of our companies. - Donald Trump in an interview with Oprah Winfrey discussing trade with Japan, 1988 Making Tariffs Great Again Donald Trump has flip-flopped on many issues. On trade, however, he has been perfectly consistent. As the quote above demonstrates, Trump has been advocating mercantilist policies ever since he entered the public spotlight in the 1980s. Even in the unlikely event that he wanted to pivot on this issue, he would be hard-pressed to do so. The Republican establishment and most Democrats will hate him no matter what he does. If Trump backpedals from his hardline stance on trade and immigration, he will lose a large chunk of his white, working-class base (Chart 1). One might argue that Trump would have no choice but to adopt a more conciliatory tone if the imposition of protectionist trade policies were to push the U.S. into a recession. However, contrary to widespread opinion, it is far from obvious that this would happen. While rising protectionism would have a major negative effect on many other economies, the impact on the U.S. would be modest, even if other countries were to match higher U.S. tariffs with retaliatory measures. Keep in mind that the U.S. is a relatively closed economy, with exports totaling only 12% of GDP. Exports to China and Mexico amount to 0.9% and 1.4% of GDP, respectively. And much of these exports are intermediate goods that are processed and reshipped back to the U.S. or some other third market. It would not make sense for China or Mexico to put up import barriers on these intermediate goods because this would just reduce domestic employment, without giving domestic firms much of a leg up. One should also remember that an appreciation of the dollar reduces U.S. export competitiveness in much the same way as higher tariffs placed by foreign governments on U.S.-made goods. The real trade-weighted dollar has appreciated by 20% since mid-2014 (Chart 2). While this obviously has been unpleasant for U.S. exporters, it has not pushed the economy into recession. Neither will retaliatory foreign tariffs. Chart 1Trump's Supporters Are Not ##br##Free Trade Enthusiasts Chart 2The Dollar Has Been ##br##Appreciating Since Mid-2014 Why The Consensus On Trade Is Misleading The view expressed above is far outside the consensus and clashes strongly with the large number of studies arguing that the implementation of Trump's trade agenda would have grave consequences for the U.S. economy. Let me first enumerate the ways these studies fall short on strictly economic grounds, and then discuss why they may still ring true if one takes a broader perspective. As far as the pure economics are concerned, these studies all suffer from some combination of the following deficiencies: They assume that foreign producers can fully or almost fully pass on the cost of U.S. tariffs to their customers. In reality, the evidence suggests that foreign producers will absorb about half of the increase in tariffs through lower profit margins. In other words, the imposition of a 20% tariff would only raise U.S. import prices by around 10%. Granted, retaliatory tariffs would squeeze the profit margins of U.S. exporters. However, this effect would be mitigated by the fact that the U.S. runs large bilateral trade deficits with China and Mexico (Chart 3), as well as the fact that foreign producers have less pricing power in the relatively large U.S. market than American producers have abroad. On net, this implies that higher trade barriers could actually make the U.S. better off by shifting the terms of trade in its favor. Chart 3The U.S. Runs Large Bilateral Trade Deficits With China And Mexico These studies treat tariffs like regular old taxes. To the extent that tariffs are taxes whose burden is partly borne by domestic consumers, their imposition has a dampening effect on activity. However, to model the impact of higher tariffs simply as a tightening of fiscal policy implicitly assumes that any tariff revenue will be used to pay down debt, rather than being used to finance tax cuts and spending increases. Given that Trump is touting a program of fiscal stimulus, that is not a sensible assumption. Moreover, unlike, say, a sales tax hike, higher tariffs divert demand towards domestically-produced goods. This tends to boost employment. These studies overstate the adverse effect of tariffs on domestic investment. More than half of global trade consists of capital equipment and intermediate goods (Chart 4). To the extent that higher tariffs raise the cost of production, this can lower investment. Moreover, trade barriers tend to increase economic inefficiencies. This can lead to slower productivity growth, causing firms to reduce capital spending. In practice, however, neither effect is particularly significant. As we discussed two weeks ago, the negative impact of trade barriers on productivity growth is generally overstated, especially for large economies like the United States.1 Chart 5 shows that productivity growth was actually faster in the three decades following the Second World War than in the hyper-globalization era that began in the early 1980s. Chart 4Intermediate And Capital Goods ##br##Make Up Over Half Of Global Trade Chart 5Rising Trade Has Not ##br##Boosted Productivity Growth While the price of capital goods does influence investment spending, for the most part, firms tend to base their investment decisions on the expected demand for their products. Since the U.S. runs a trade deficit, an equal percentage-point decline in both exports and imports would increase final demand through the familiar Y=C+I+G+X-M identity. This should lead to higher investment. Moreover, even if higher trade barriers leave final demand unaffected, there are reasons to think that investment would still rise. Think about a closed economy where most households decide all of a sudden that they prefer strawberry ice cream over vanilla ice cream. Let us assume, just for the sake of argument, that shifting production from vanilla to strawberry ice cream is very difficult and requires a lot of new investment. What do you expect would happen to overall investment in this economy? The answer is that it would likely rise, as companies scramble to build out new strawberry ice cream-making capacity. Now extend the analogy to trade. If the U.S. slaps tariffs on manufacturing imports, this will lead to a wave of new domestic investment in industries that benefit from tariff protection. This is bad news for companies that must incur the cost of relocating production back onshore, but it is good news for American workers who can now find gainful employment. The Bigger Picture Our guess is that in purely economic terms, the U.S. would not suffer much if the Trump administration were to forge ahead with its protectionist trade agenda, and could actually benefit if America's trading partners felt restrained in how they could retaliate. Yet, focusing only on the economics misses the bigger picture. Trade agreements are also about politics - they help form the geopolitical glue that holds the global community together. As we noted two weeks ago, the real reason the 1930 Smoot-Hawley Tariff Act was so disastrous was not because it contributed to the Great Depression, but because it led to a breakdown of international relations among democratic governments at a time when fascism was on the rise.2 Donald Trump's threat to pull out of trade deals and unilaterally impose tariffs on countries that he feels are engaging in unfair trade practices is likely to accelerate the shift to a multipolar geopolitical order where competing countries strive to carve out their own spheres of influence. As Chart 6 shows, such geopolitical orders have often contributed to the breakdown of globalization, and at times, have even led to military conflict. Chart 6AIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand Chart 6BIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand The fact that rising protectionism could benefit the U.S. at the expense of other countries is bound to stoke anger abroad. China, the focus of much of Trump's rhetoric, is especially vulnerable. Trump has threatened to declare the country a "currency manipulator," even though it meets only one of the three criteria for such a designation as set out by the Treasury Department.3 Other countries should not breathe a sigh of relief, however. There is a certain logic about protectionism that makes it difficult to hike tariffs on just one or two countries. For example, if the U.S. raises tariffs on China, some of the existing demand for Chinese goods will be diverted to countries such as Korea or Vietnam, rather than back to the U.S. This creates an incentive to raise tariffs on those countries as well. It is easy to see how the whole global trading system can break down under such circumstances. Investment Conclusions Donald Trump's threat of across-the-border tariffs of 35% on Mexican goods and 45% on Chinese goods will likely turn out to be a negotiating ploy. That said, some increase in trade barriers seems inevitable. These need not even be explicit barriers. Trump's success in browbeating Carrier into keeping its plant open in Indiana is an example of things to come. Corporate America does a lot of business with the government, and the subtle threat of cancelled government contracts will make any CEO take notice. Good news for Main Street perhaps, but definitely bad news for Wall Street. For now, investors are focusing on the positive elements of Trump's agenda. That may change soon. Yes, increased infrastructure spending and corporate tax cuts are both bullish for stocks. However, effective U.S. corporate tax rates are already quite low thanks to numerous loopholes. Thus, any cuts to statutory rates may not boost S&P 500 profits by as much as investors are hoping (Chart 7). And while more infrastructure investment is welcome, there simply are not enough "shovel ready" projects around. Chart 7U.S. Effective Corporate Tax Rate Is Already Quite Low Moreover, Trump's plan to finance infrastructure spending through private-public partnerships greatly narrows the universe of possible projects. The U.S. Society Of Civil Engineers estimates that most of the "infrastructure gap" consists of deferred maintenance (i.e., potholes to fix, bridges to repair).4 It is difficult to get investors interested in such work, which is why it is typically financed directly through government budgets. Meanwhile, financial conditions have tightened via a stronger dollar and higher bond yields (Chart 8). Historically, such a tightening has been bearish for stocks (Table 1). We are tactically cautious on a three-month horizon, and are positioned for this by being short the NASDAQ 100 futures. Our guess is that global equities will correct by about 5%-to-10% from current levels, setting the stage for positive returns down the road. U.S. high-yield spreads, which are near post-crisis lows, are also likely to widen (Chart 9). Chart 8U.S. Financial Conditions Have Eased Chart 9U.S. High-Yield Spreads Likely To Widen Table 1Stocks Tend To Suffer When Bond Yields Spike A correction in risk assets could temporarily knock down Treasury yields. Nevertheless, the long-term path for global bond yields is to the upside. The three key features of Trump's platform - fiscal stimulus, tighter immigration controls, and trade protectionism - are all inflationary. Only JGB yields are likely to stay put for the foreseeable future due to the BOJ's well-timed decision to peg the 10-year yield at zero. As bond yields elsewhere rise, the yen will come under further downward pressure. We see USD/JPY reaching 125 in 12 months' time. Chart 10Global Growth Is Accelerating A weaker yen should boost Japanese stocks, at least in local-currency terms. European equities will also benefit from a somewhat cheaper euro and firming global growth (Chart 10). Steeper yield curves are helping to boost European bank shares, despite ongoing concerns about the health of the Italian financial sector. As we have discussed in the past, systemic risks around the Italian banks are overstated.5 With that in mind, we are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. The recent rally in commodity markets and the uptick in global activity indicators are welcome developments for emerging markets. Still, it will be hard for EM equities to muster a sustainable rally as long as the dollar remains in an uptrend and protectionist sentiment is on the rise. For now, a modest underweight in EM stocks is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1,2 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 3 The U.S. Treasury is allowed to define a country as a currency manipulator if: i) it runs a large trade surplus with the U.S.; ii) it has an excessively large current account surplus with the rest of the world; and iii) it is engaging in direct foreign exchange intervention in order to weaken its currency. While the first criterion arguably holds, the other two do not, given that China's overall current account surplus currently stands at 2.4% of GDP and recent currency intervention has been designed to prevent the yuan from depreciating more than it would have otherwise. 4 Please see "Failure to Act: Closing the Infrastructure Investment Gap for America's Economic Future," American Society of Civil Engineers (2016). 5 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The Chinese authorities have progressively tightened capital account control regulations to staunch capital outflows, which will likely slow the drawdown of the country's official reserves in the near term. Rising yields in China are largely reflective rather than restrictive. Monetary easing through interest rate cuts has likely run its course, but it is highly unlikely that the PBoC will raise rates to protect the RMB. The Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Feature The mighty U.S. dollar occupied the cover of this week's Economist magazine - it has also clearly occupied the top spot on our clients' 'worry lists'. We were in China last week talking to clients and conducting some "field research", and the yuan's depreciation was a key focal point of the discussions. Historically, Economist magazine cover stories have mostly turned out to be perfect contrarian signals, and it remains to be seen whether this one will be a blessing or curse for the greenback. What's more certain is that there is a clear consensus among Chinese investors on the one-way descent of the RMB against the dollar going forward, and the People's Bank of China (PBoC) is facing an uphill battle in containing domestic capital outflows. The latest program linking Chinese equities and the overseas market is the Shenzhen-Hong Kong connect program, which debuted early this week. This suggests the Chinese authorities are still committed to capital account deregulation. In the near term, however, capital control measures have been tightened progressively to preserves official reserves and maintain domestic liquidity. Full-Court Press Heightened concerns over the CNY/USD cross rate of late have ignored the fact that the RMB has remained one of the stronger currencies among a synchronized plunge against the seemingly unstoppable dollar. The trade-weighted RMB has picked up notably in recent weeks, even though it has depreciated against the greenback (Chart 1). Nonetheless, Chinese investors' perception of the currency matters greatly, as it could potentially create a self-fulfilling downward spiral between capital outflows and exchange rate depreciation. It is both naïve and highly risky to expect the RMB to settle down at a "market clearing" level against the dollar without a chaotic undershoot. The "Impossible Trinity" theory in international finance dictates that a country cannot simultaneously control its exchange rate with independent monetary policy and free flow of capital. Among these conditions, free flow of capital has been the least expensive sacrifice for the Chinese authorities.1 In basketball, full-court press refers to a defensive tactic in which members of a team cover their opponents throughout the court, and not just near their own basket. This is what the Chinese authorities appear to be doing in terms of their efforts at staunching capital outflows. Cracking down on underground money smugglers facilitating RMB conversions with other currencies, particularly in regions neighboring Hong Kong. Anecdotal evidence suggests a sharp slowdown in illegal money transfers. Tightening scrutiny on trade invoicing verifications to crack down on "fake" international trades. Chinese imports from Hong Kong, sky-high last year as Chinese local firms fabricated import businesses to move money offshore, have tumbled to a fraction of last year's peak level (Chart 2). Restricting Chinese nationals from purchasing insurance policies issued by Hong Kong insurance firms. The massive boom of Hong Kong insurance sales to mainland residents in recent years will likely see a significant setback (Chart 3). Chart 1The RMB's Depreciation In Perspective Chart 2Blocking Capital Leakage In Trade... Chart 3...Services... These restrictive measures have been either targeting illegal channels or activities that are of minor importance to the economy as a whole. More recently, the authorities have also begun tightening rules on direct overseas investment by Chinese firms. Projects over US$10 billion and investments in "non-core" businesses are being tightly scrutinized. As companies' overseas expansion efforts are largely strategic in nature and tend to be long term, policymakers are potentially sacrificing long-term economic interests for a near-term fix of capital leakage. This underscores the authorities' increasing anxiety over capital outflows. Chart 4 shows net FDI outflows have become a major source of China's capital outflows in recent quarters, while Chinese firms paying off foreign liabilities was previously the main reason.2 Moreover, there has been a rush to acquire foreign assets among large Chinese firms this year, which is probably partially motivated by avoiding exchange rate losses (Chart 5). Chinese overseas investment activity will likely slow down significantly in the near term. Chart 4...And Outward Direct Investment Chart 5Overseas M&A Under Scrutiny Yesterday's data release show Chinese official reserves dropped to USD 3.05 trillion in November, down USD 69 billion from October. On surface, this is a marked deterioration from previous months. Underneath, however, our calculation shows that the decline in the headline official reserve number is more than explained by the mark-to-market paper losses from both a strengthening dollar and rising interest rates in the U.S. in the past month. Non-dollar assets account for about half of Chinese official reserves, and the 5% surge in the U.S. dollar index last month alone should have led to about $75 billion paper losses in the dollar value of Chinese reserves. Meanwhile, Chinese holdings of U.S. treasuries and agency bonds amount to about USD 1.4 trillion, and the sharp spike in U.S. risk free rates last month should have shaved off at least USD 30 billion in value. Taken together, the mark-to-market losses of Chinese reserve holdings are should be substantially higher than the decline in reserves last month. This may suggest that China's all-out efforts to stabilize capital outflows have been effective and should further reduce the drawdown of the country's official reserves. P.S. Over the years, we have been running a series of Special Reports tracking the composition and evolvement of China's foreign reserves. This year's update will be published next week. Stay tuned. Chart 6Interest Rate Vs Exchange Rate Will Interest Rates Be The Next Shoe To Drop? Chinese interest rates have also begun to pick up in recent weeks, as the RMB has continued to depreciate against the dollar (Chart 6). The increase in interest rates so far has been much milder compared with mid-2015, when RMB/USD depreciation sparked widespread financial volatility. Some have attributed China's higher interest rates to a weakening currency - as a sign that the country's monetary policy independence has been undermined. Recently, a senior PBoC official hinted that the central bank can raise interest rates if necessary to counter the downward pressure of the RMB, which further reinforces this view. Raising interest rates has been a typical policy response, especially among emerging countries look to defend their exchange rates, but it has rarely been proven successful. Hiking rates at a time of currency weakness further weakens domestic growth, which can in turn reinforce additional downward pressure on the exchange rate. The PBoC could certainly raise its benchmark rate, but we doubt the central bank is at all considering this option. In our view, the recent rise in Chinese interest rates may be attributable to both domestic and global factors: Globally, the synchronized selloff of bonds in major countries may have also pushed up Chinese interest rates. Chinese 10-year government bond yields have increased by 45 basis points since their August lows, not extraordinary considering the 102-basis-point selloff in U.S. Treasurys (Chart 7). Domestically, stronger growth numbers reported of late are providing additional evidence of growth improvement, which may have led to an adjustment in Chinese interest rate expectations (Chart 8). The latest PMI numbers point to further acceleration in both manufacturing and service industries, while the growth "surprise index" has been gradually improving and the yield curve has been steepening. Chart 7Higher Chinese Yields Reflect Global Factors... Chart 8... And Growth Improvement In short, we view rising yields in China as largely reflective rather than restrictive. As such, the PBoC is unlikely to rush in to push yields down just yet. In terms of monetary policy, we maintain the view that China's monetary easing through interest rate cuts has likely run its course, at least in the near term. Nonetheless, raising interest rates to protect the RMB would be a major policy mistake that would further undermine the exchange rate. Chart 9Cheaper Hong Kong Valuation Attracts ##br##Chinese Domestic Capital The Shenzhen-Hong Kong Connect Compared with the Shanghai-Hong Kong program that started over two years ago, the Shenzhen-Hong Kong connect program that debuted early this week has been received with much less enthusiasm from investors on both sides. The muted response in the marketplace likely reflects generally depressed sentiment within both Chinese and Hong Kong bourses. Given the large gap between Chinese domestic A shares and Hong Kong-listed stocks and well-entrenched expectorations of further RMB weakness, Chinese investors' purchases of Hong Kong-listed shares, or southbound purchases, will likely continue to increase (Chart 9). The establishment of the Shenzhen-Hong Kong connect program is also another step in liberalizing China's capital account controls. While in the near term this contradicts the authorities' recent efforts to block capital outflows, the new stock connect channel is subject to daily quotas, and capital movement is under close scrutiny. Meanwhile, capital flows through the stock exchanges are tiny compared with economic activity. In the past two years, Chinese domestic investors' cumulative "southbound" net purchases of Hong Kong-listed stocks only amounted to RMB 200 billion, or US$30 billion, a fraction of the country's capital movement and foreign reserve holdings. As far as investors are concerned, a major difference between the two Chinese domestic exchanges is their sectoral composition. The Shanghai Stock Exchange is heavily concentrated in the financial sector and state-controlled enterprises (Table 1). The Shenzhen Stock Exchange, on the other hand, is more tech-heavy with larger representation of private firms, and therefore has been more dynamic, which is also reflected in its stock prices. The Shenzhen stock index has outperformed that of Shanghai massively in recent years (Chart 10). In this vein, opening Shenzhen stocks directly gives overseas investors another option to tap into some of China's fastest growing sectors. This could also increase the odds that MSCI Inc. may include Chinese domestic stocks in its widely followed EM and global indices in its next review. Table 1Sectoral Components Of Shanghai And ##br##Shenzhen Exchanges Chart 10Shenzhen Market's Secular Outperformance##br## Against Shanghai The bottom line is that the Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization, allowing freer access between Chinese and overseas investors to each other's financial assets. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed Chart 2Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here Chart 4Good Entry Point To Consumer Products? As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance Chart 6Consumers: The Future##br## Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com
Highlights Despite the static headline GDP figures, most of our indicators suggest Chinese growth momentum has improved since the second quarter, particularly in the industrial sector. A dollar overshoot, domestic housing policy tightening and potential policy mistakes by the Chinese authorities need to be monitored for potential growth disappointments. The rally in commodity prices reflects improving Chinese demand, but it has ignored the surging dollar. Chinese H shares are a safer play on Chinese reflation and growth improvement. Feature Our recent conversations with clients suggest that global investors' concerns over China have slightly abated, as various economic numbers have shown improvement. Nonetheless, investors remain highly sceptical about China's macro situation, raising questions ranging from "traditional" distrust of China's economic data to the latest worries of a "trade war" with the U.S. under President Donald Trump. We dedicate this week's report to addressing some common issues that we have been discussing with clients of late. What Is The Actual GDP Growth In China? In Recent Quarters, It Seems To Be Holding In A "Too-Good-To-Be-True" Tight Range? Chinese real GDP growth has been 6.7% for the past three consecutive quarters, right in the middle of the government's official target of 6.5-7%. This seemingly incredible stability has stoked long-held suspicions among investors about the reliability of Chinese economic data. While we do not claim to have the ultimate insider story on official Chinese statistics, and it is certainly possible that the macro numbers are "smoothed out" to hide otherwise greater volatility in economic reality, it is also possible that stable headline numbers overshadow bigger underlying fluctuations among different sectors (Chart 1). Chart 1Greater Volatility Underneath ##br##Stable GDP For example, while real GDP growth has stayed at 6.7% since Q1 this year, there has been some fluctuations in both the industrial and service sectors. Within the service sector, the financial industry has had a major downturn, with nominal growth falling from 10.9% in Q1 to 8.2% in the last quarter, partly due to last year's base effect of the stock market boom-bust. The real estate sector, on the other hand, has been on the mend, with growth strengthening from 14% in Q1 to 16.3%. Regardless, the exact GDP growth figures rarely matter from an investor's perspective. What is more important is the growth trajectory and policy implications. On this front, most of our indicators suggest growth momentum has improved since the second quarter of the year, particularly in the industrial sector. A strong recovery in manufacturing-sensitive indicators such as railway freight, heavy machine sales and electricity consumption (Chart 2). Continued acceleration in profit growth, in both the overall industrial sector and among listed firms.1 Further improvement in pricing power and producer prices. Producer price deflation that lasted for over four years ended in September, compared with 5.3% deflation in January. Looking forward, we expect the economy to continue to improve, even though some of the high-flying variables may begin to moderate. On the policy front, the authorities will likely enter a wait-and-see mode, especially on interest rates. Our model signals that the central bank's interest rate cuts have likely come to an end, unless the economy relapses again (Chart 3). This is also reflected in the pickup in interest rates in the bond market. We will further explore China's growth outlook, policy orientation and investment implications for the New Year in the first week of 2017. Chart 2Broad Improvement In##br## Industrial Indicators Chart 3No More Rate Cuts, ##br##For Now There Appears To Be Growing Acceptance In The Market That China Will Not Suffer A Hard Landing. What Are You Monitoring To Gauge The Growth Risk? We have not been in the "hard landing" camp, and have been anticipating a "rocky bottoming" process in Chinese growth for the year.2 Despite enormous financial volatility in January associated with the domestic stock market and the RMB, growth has largely played out as we anticipated. We expect the economy to remain resilient, but are watching some pressure points that could lead to disappointments. The first is the RMB, which has been depreciating notably against the dollar in recent weeks, as the dollar uptrend has resumed with vigour. In our view, a strong dollar is one of the key risks, as it not only generates downward pressure on the CNY/USD cross rate, on which the market tends to focus closely, but also halts the "stealth" depreciation of the RMB in trade-weighted terms, which reduces the reflationary benefits of a weaker exchange rate on the Chinese economy (Chart 4). In other words, a weak CNY/USD and a strong trade-weighted RMB is a poor combination for both financial markets and the macro economy.3 So far, the CNY/USD decline appears orderly, and we doubt the greenback will massively overshoot against all major currencies within a short period without causing growth difficulties in the U.S. However, the situation should be closely monitored and continuously assessed. The second is housing policy tightening, which the authorities have re-imposed since October to check rapid gains in home prices. So far, the tightening measures have not led to a significant slowdown in home sales in major cities: Daily home sales in the major cities that we track have broken out to new record highs (Chart 5). However, new housing supply has already been very weak, which together with robust sales could lead to even lower housing inventory and a further spike in home prices. We maintain guarded optimism on China's housing construction, as we discussed in detail in our previous report.4 The risk is that unyielding home price gains will force the Chinese authorities to up the ante on tightening, which could lead to a sudden deterioration in housing activity. In this vein, price moderation should be good news from policymakers' perspectives, as well as for the overall economy. Chart 4The RMB: Weak Or Strong? Chart 5Monitor Housing Activity Finally, as we have argued repeatedly, China's growth difficulties in recent years have had a lot to do with the excessively tight policy environment post the global financial crisis - a policy mistake that compounded deflationary pressures in the economy, which had already been suffering from weak external demand. Despite budding improvement in the economy, China's overall macro environment remains highly challenging, and policy mistakes that undermine aggregate demand will prove extremely costly. In this vein, any broader attempt to tighten policies, hasten administrative enforcement to de-lever or prematurely withdraw fiscal support on infrastructure construction will prove counterproductive. A more recent risk is how China deals with the potential protectionist threat from the U.S. under President Donald Trump.5 Our view is that China should avoid escalating trade tensions with tic-for-tac retaliations that could further complicate the growth outlook. As far as the markets are concerned, Chinese equities appear to have begun to price in a lower "China risk premium." Forward P/E ratios for both A shares and H shares have been rising since early this year, likely a reflection of investors' easing anxiety on China's macro conditions (Chart 6). Nonetheless, Chinese stocks' forward P/E ratios remain well below other major markets and the global average, and the risk premium in Chinese equities is still substantially higher than historical norms. Beyond near-term volatility, we expect the risk premium in Chinese stocks to continue to revert to the mean, leading to multiples expansion and further price gains. At minimum, Chinese equities should outpace global and EM benchmarks. There Has Been A Massive Rally In Some Industrial Commodity Prices In China. Is This Driven By Speculative Frenzy? How Much Does The Commodities Rally Reflect Chinese Demand? Industrial commodity prices have rebounded sharply in both the Chinese domestic spot markets and various derivatives exchanges. For some products, prices have gone parabolic, and there is little doubt that these extreme moves cannot be fully explained by fundamental factors (Chart 7). Nonetheless, it is also well known that commodities in general are subject to volatile price fluctuations, as they are extremely sensitive to marginal shifts in the supply-demand balance due to very low price elasticity among both producers and end users. Therefore, it is impossible, and rather meaningless, to precisely detangle speculative forces and fundamental factors. Chart 6Risk Premium Will Continue ##br##To Mean Revert Chart 7No Clear Evidence Of Commodity ##br## Speculative Frenzy That said, from a macro perspective, a few observations are in order: There does not appear to be a particularly high level of over-trading and speculative activity involved this time around compared with historical norms. Futures transactions this year have been hovering at close to record low levels, despite sharp prices gains in numerous products. Even if prices decline sharply, the impact on the financial system should be negligible because of very low investor participation. Broad-based improvement in numerous industry-sensitive indicators shown in Chart 2 on page 2 suggest the gains in commodity prices are at least partially attributable to improving demand rather than purely driven by speculative frenzy. In fact, improving Chinese demand is also reflected in a firmer global shipping rate. The Baltic Dry Index has almost quadrupled since its February lows, which hardly has anything to do with Chinese retail speculators (Chart 8, top panel). Massive price gains in some commodities such as steel and coal have been partially driven by the Chinese authorities' attempts early this year to "de-capacity" the two sectors, with aggressive efforts to cut idle capacity and reduce domestic production. The self-imposed restrictions together with improving demand have led to sharp price gains and a significant rebound in imports of related products (Chart 8, bottom panel). This confirms our view that the overcapacity issue in the Chinese industrial sector has been overestimated.6 Moreover, regulators' control on domestic supply has been relaxed, which will likely lead to rising domestic production in due course - this bodes well for Chinese domestic business activity, but poorly for the prices of related products. Historically, commodity prices have been positively correlated with China's growth trajectory, and negatively correlated with the trade-weighted dollar (Chart 9). Currently, the commodities rally clearly reflects regained strength in Chinese industrial activity, but has ignored the recent strength of the greenback, leading to a glaring divergence that has been very rare in recent history. Chart 8More Signs Of ##br## Improving Demand Chart 9Macro Drivers And Commodity Prices: ##br##Mind The Gap It remains to be seen how such a divergence will eventually converge. Our hunch is that the dollar will likely continue to rally in the near term, which means commodity prices could converge to the downside. Our commodities team has upgraded base metals from underweight earlier this year on China's reflation efforts, and is currently neutral on the asset class. What is more certain, however, is that China's reflation efforts and growth improvement should also lift Chinese H shares, but the price gains of H shares so far have been much more muted. Earlier this year we recommended going long Chinese H shares against the CRB index, which so far has been flat. We are still comfortable holding this position. The bottom line is that we do not advocate chasing the current rally in base metals. Chinese H shares are a safer play on Chinese reflation and growth improvement. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming", dated January 6, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?", dated November 24, 2016; and "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com 6 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity", dated October 6, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations