Europe
Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... Chart 4... And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Chart 8Here Comes Pork! By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.
Highlights Persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale. Hence, the risk is that financial market distortions will infect the economy, not the other way round. A global mini-downturn in the first half of 2018 is now all but guaranteed. High conviction equity sector recommendation: underweight the major cyclical equity sectors: specifically, Banks, Materials and Energy; but overweight Airlines. High conviction currency recommendation: yen first; euro second; pound third; dollar fourth. Feature Stock markets ascend by walking up the stairs, but they descend by jumping out of the window. Unfortunately, investors often misinterpret the low volatility of a market ascent as a sign that equity risk has diminished. In fact, the low volatility just tells us that walking up the stairs is a slow and dull process (Chart I-2). It tells us nothing about equity risk. Chart of the WeekA Global Mini-Downturn In H1 2018 Is Now All But Guaranteed Chart I-2Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window The risk of equities, as we have just seen, is that they do periodically jump out of the window. Meaning that equities have the potential to suffer much more intense short-term losses than short-term gains. This ratio of potential losses to potential gains is technically known as negative skew. For a reminder why equity returns have this unattractive asymmetry, please revisit our Special Report 'Negative Skew': A Ticking Time-Bomb.1 That said, equity returns always possess negative skew, so there is nothing new about stock markets jumping out of the window, as they have this week. Persistent QE, ZIRP And NIRP Have Created A Severe Financial Distortion The much bigger story is that persistent QE, ZIRP and NIRP2 have imparted negative skew on bond returns too. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Approaching this lower bound for yields, bond prices have diminishing upside with increasing downside (Chart I-3). So at low bond yields, mathematics necessarily forces bond markets also to walk up the stairs and then jump out of the window (Chart I-4 and Chart I-5). Chart I-3Approaching The Lower Bound For Yields, Bond Prices ##br##Have Diminishing Upside With Increasing Downside Chart I-4In A Low Yield Era, Bond Markets ##br##Also Climb Up The Stairs... Chart I-5... And Then Jump Out ##br##Of The Window As the risk of owning 10-year bonds has increased to become 'equity-like', it has removed the requirement for an excess return, a risk premium, on equities. In other words, persistently ultra-accommodative monetary policy has diminished the prospective 10-year annual return on global equities to become 'bond-like', collapsing from 9% in 2012 to 1.5% today - exactly the same rate of return that is now offered by the global 10-year bond (Chart I-6). In effect, persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds. Chart I-6Equities' Prospective Returns##br## Have Become 'Bond-Like' However, as we explained last week in Beware The Great Moderation 2.0,3 the nose-bleed valuation of the world stock market is justified only as long as bond yields stays low. Above a 2% yield, the payoffs offered by bonds gradually lose their negative skew and thereby become less risky than those offered by equities. So equities must once again compensate by offering an excess prospective return, necessitating a derating of today's elevated valuations. Specifically, we wrote that the big threat to equity valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." To which one client responded "markets do not respect round numbers... if the trigger-point is 3%, then you must act well before that." Wise words indeed. The U.S. 10-year T-bond yield got as far as 2.88% before triggering a reversal in equity valuations. Financial Distortions Threaten The Real Economy Chart I-7Financial Conditions 'Easiness' Is Just ##br##Tracking The Stock Market Many people naturally assume that the economy drives the financial markets. This may be true some of the time, or even most of the time. But in the last three downturns, the causality ran the other way round - financial market distortions dragged down the economy. The bursting of the dot com bubble triggered the downturn in 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession in 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession in 2011. Which begs the question: is there a financial distortion or mispricing that could once again drag down the economy? The answer is an emphatic yes. To repeat, six years of persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale, compressing the prospective 10-year annual return on world equities from 9% to 1.5%.4 Thereby, equity returns which would have accrued in the future have been brought forward to the here and now in the form of elevated capital values. But if higher bond yields correct the severely distorted valuation relationship between equities and bonds, the effect will be to move these returns from the present back to the future, depressing capital values today. Now note that while world GDP is worth around $80 trillion, the combination of equities and correlated risk-assets such as corporate and EM debt is worth double that, around $160 trillion, and real estate is worth $220 trillion. If returns from these richly valued asset-classes are redistributed from the present back to the future, through lower capital values today, there is a very real risk that current spending could take a hit. Supporting this broad thesis, central bank measures of 'financial conditions easiness' just track tick for tick the level of the stock market (Chart I-7). What To Do Now The upturn in bond yields which started last summer threatens to impact activity through two separate channels. As just discussed, the first is the financial market channel via a setback to global risk-asset capital values. The second is the bank credit channel. Changes in the bond yield very clearly and reliably lead changes in credit flows, the credit impulse, by 6 months. Therefore, the rise in bond yields is only now starting to pull down the credit impulse - and thereby the global activity mini-cycle, which is the all-important driver of mainstream European investments. It follows that a global mini-downturn in the first half of 2018 is now all but guaranteed (Chart of the Week). And that the higher that bond yields go from here, the more marked this mini-downturn will be. This reinforces two high conviction investment recommendations. First, it is now appropriate to underweight cyclical equity sectors: specifically, Banks, Materials and Energy. Against this, the one cyclical sector to upgrade to overweight is Airlines, given the sector's negative correlation with the oil price. Second, the payoff profile for exchange rates is just tracking expected long-term interest rate differentials (Chart I-8). This means that when the expected interest rate is close to the lower bound, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy - such as the BoJ and ECB - the direction of policy rate expectations cannot go significantly lower. Conversely, tightening expectations for the Federal Reserve are approaching a magnitude that threatens either risk-asset prices and/or economic growth. So these expectations cannot go significantly higher (Chart I-9). Chart I-8Exchange Rates Are Tracking Long-Term ##br## Interest Rate Differentials Chart I-9Expected Interest Rates In The Euro Area And ##br##U.S. Will Converge One Way Or The Other On this basis, we reiterate our high conviction pecking order for currencies in 2018. Yen first; euro second; pound third; dollar fourth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'Negative Skew: A Ticking Time-Bomb', July 27 2017 available at eis.bcaresearch.com. 2 Quantitative Easing, Zero Interest Rate Policy and Negative Interest Rate Policy. 3 Please see the European Investment Strategy Weekly Report, 'Beware The Great Moderation 2.0', February 1 2018 available at eis.bcaresearch.com. 4 This 1.5% forecast comes from regressing the world equity market to GDP multiple through 1998-2008 with subsequent 10-year returns, observing a very tight relationship, and then using the same relationship on current world equity market cap to GDP. Fractal Trading Model* This week's recommended trade is to go long utilities versus the market. The profit target is 3.5% outperformance with a symmetrical stop-loss. It was an excellent week for our other trades with short palladium hitting its 6% profit target, while underweight Japanese energy and long USD/ZAR are both in comfortable profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation
Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Chart I-10Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Duration Checklist: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. UST-Bund Spread: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Feature Chart of the WeekUST-Bund Gap Still##BR##Reflects Policy Differences With the 10-year yield on both U.S. Treasuries and German Bunds hitting new cyclical highs on an intraday basis yesterday (2.72% and 0.70%, respectively), it is clear that the backdrop for global government bond markets is still bearish. The yield differential between the two markets remains quite wide, however, with the cyclical European economic performance rapidly catching up to that in the U.S. This is raising the odds that European Central Bank (ECB) will have to soon begin signaling a move to a less accommodative policy stance that will raise European bond yields further away from historically low levels. The continued strength of the Euro versus the U.S. dollar is a sign that investors are already expecting a big compression in U.S. bond yields versus European equivalents (Chart of the Week). Should investors position now for an eventual tightening of the Treasury-Bund spread? Or is it possible that the spread widens even further, thus providing a better entry point to profit from a spread tightening move? In this Weekly Report, we investigate the drivers of the Treasury-Bund spread to provide some clues as to its future direction. Our conclusion is that, from a medium-term strategic perspective, a narrowing of the Treasury-Bund spread is highly probable, but there is still potential for widening in the next few months. Checking In On Our Duration Checklist: Still Bearish, But With No Big Signal For U.S.-German Spreads In early 2017, we introduced a list of indicators to monitor in order to determine if our strategic below-benchmark duration stance on U.S. Treasuries and German Bunds should be maintained.1 This list, which we dubbed our "Duration Checklist", contained elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The vast majority of indicators in the Checklist have accurately pointed to a cyclical backdrop for rising yields throughout the past year, despite the surprising drop in global inflation witnessed in 2017 (Table 1). Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds With bond yields hitting fresh cyclical highs this week, it is a good time to provide another update of our Duration Checklist to see how conditions have changed since our last update in September. Specifically, we are looking for any differences in the individual U.S. and European components of the Checklist that can inform our view on the UST-Bund spread. Global growth momentum is accelerating to the upside. The global leading economic indicator (LEI) continues to climb steadily higher, even with global growth already in a solid uptrend (Chart 2). The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has started to accelerate. The Citigroup Global Data Surprise index is at the highest level since 2004 (!), while our global credit impulse indicator has picked up sharply - both of which should keep global bond yields under upward pressure. We are giving a "check" to all these elements of our Duration Checklist, indicating that a defensive stance on overall duration exposure should be maintained. The only indicator in the "global" section of our Duration Checklist that is not pointing to higher bond yields is our global LEI diffusion index, which has fallen to just below the 50 line. This suggests a potential narrowing of the breadth of the current global upturn, which warrants an "x" in the Checklist. Domestic economic growth in both the U.S. and Euro Area remains solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe remain high and are rising, as is consumer and business confidence on both sides of the Atlantic (Charts 3 & 4). Corporate profit growth is solid both in the U.S. and Europe, with our models suggesting that earnings should expand at a double-digit pace again in 2018. All these indicators earn a "check" in our Duration Checklist. Chart 2Majority Of Global Growth Indicators##BR##Still Pointing To Higher Yields Chart 3U.S. Growth##BR##Remains Solid Chart 4A Booming European##BR##Economy Is Bearish For Bunds Inflation signals are mixed both in the U.S. and Europe. This remains the portion of our Checklist that has the greatest number of conflicting signals. While the rapid rise in oil prices over the past several months is putting upward pressure on headline U.S. inflation (Chart 5), the equally fast increase in the EUR/USD exchange rate is helping offset much of that increase in the Euro Area (Chart 6). Unemployment is below the OECD's estimate of the full employment NAIRU rate in the U.S., yet both Average Hourly Earnings growth and the Atlanta Fed Wage Tracker are decelerating. Unemployment in the Euro Area is now back to the OECD'S NAIRU level for the first time since the Great Recession, but wage inflation has only risen modestly. Chart 5U.S. Inflation Still Subdued,##BR##Despite Higher Oil & Low Unemployment Chart 6A Puzzling Lack Of##BR##Euro Area Core Inflation For the U.S. inflation side of our Checklist, we are giving a "ü" to the accelerating oil price (in U.S. dollar terms) and the unemployment gap, but an "x" to decelerating wage inflation. In the Euro Area, we give a "check" to the unemployment gap and a weak "check" to wage inflation which is in a mild uptrend. The stable momentum in the Euro-denominated Brent oil price earns an "x" in the Checklist, however. Both the Fed and ECB Are Looking To Tighten Monetary Policy. The Fed remains in a tightening cycle and with U.S. growth strong, core inflation bottoming out and the labor market still tight, there is no reason why the Fed should not deliver on its projected three rate hikes in 2018. The ECB just reduced the size of its monthly asset purchases in response to the robust Euro Area economic growth and modest pickup in inflation. The latest comments from various ECB officials suggests that, if core inflation rebounds after the recent unusual dip, then additional moves to less accommodative monetary policy (tapering first, rate hikes later) should be expected. So for both the U.S. and Europe, we place a "check" in this portion of the Duration Checklist. Investors risk appetite remains strong. The surge in global stock markets seen so far in 2018 has definitely played a role in the backup in global bond yields, as investors have been allocating out of fixed income into equities. Within our Duration Checklist framework, a bearish signal for bonds occurs if the percentage deviation of equity indices from their 200-day moving average is positive but is not yet at 10% - a stretched level that has typically preceded significant equity corrections. The S&P 500 index is now 14% above its 200-day average, and thus earns an "x" in that element of the Duration Checklist. The other parts of the U.S. side of the Checklist - tight corporate bond spreads and a low level of the VIX volatility index - both warrant a "check" as an indication of intense investor risk appetite that lessens the appeal of government bonds (Chart 7). In the Euro Area, the Stoxx 600 index is only 4% above its 200-day moving average, but with tight credit spreads and a low level of the VStoxx volatility index (Chart 8). All these elements earn a "check" in our Duration Checklist. Chart 7High Risk Appetite In the U.S.,##BR##But Risk Assets Look Stretched Chart 8Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond market momentum is not overly stretched, although short positioning is an issue. In the U.S., the 10-year Treasury yield is only 35bps above its 200-day moving average, well below the 90-100bps levels seen at previous yield peaks (Chart 9). Price momentum for the 10-year is right on the zero line, suggesting no stretched extreme that would precede a reversal. Both of those indicators earn a "check" in the Checklist. Positioning is a problem in the U.S., however, with the CFTC data on Treasury futures showing a net short position on the 10-year contract among speculators. From the point of view of our Duration Checklist, a big net short is a bullish signal for bonds from a contrarian perspective. Thus, positioning warrants an "x" in the U.S. side of the Checklist. In Europe, the 10-year Bund yield is now 22bps above its 200-day moving average. This is below the previous peaks around the 50bps level. Price momentum is also hovering just above the zero line and is no impediment to a move higher in yields (Chart 10). Both of these pieces of the Duration Checklist score a "check". Note that due to a lack of available data, we do not include a positioning component on the European side of the Checklist. Chart 9USTs Not Oversold,##BR##But Positioning Getting Stretched Chart 10Bunds Not Yet At##BR##Oversold Extremes The net conclusion from our Duration Checklist is that the majority of indicators continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, a below-benchmark duration stance is still warranted for both markets. There are only a few potentially bullish signals in the Checklist. The overshoot in U.S. equity markets and the large net short position in Treasury futures are both sending a more positive signal for Treasuries, while the more stable momentum in the Euro denominated oil price is also a positive for Bunds. None of those is enough to prompt a change in our recommended below-benchmark duration stance. At the same time, there is not enough of a difference between the U.S. and European sides of the Checklist to provide a signal for the future direction of the Treasury-Bund spread. For that, we must dig a bit deeper into the drivers of that spread, which we cover in the next section. Bottom Line: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. How To Play The Treasury-Bund Spread - Tactically Wider, Structurally Narrower The Treasury-Bund spread, like most cross-country bond yield spreads, is driven mostly by economic growth and inflation differentials. In the past, the U.S. and European economic cycles have rarely been in sync, which creates gaps in growth, inflation and monetary policy between the two regions. This usually leads to the Fed and ECB (and the Bundesbank before it) rarely having interest rates at similar levels, or moving at a similar pace, thus creating large cyclical swings in the Treasury-Bund spread. At the moment, however, the 200bp gap between 10-year Treasuries and German Bunds mostly reflects the 4.6 percentage point gap between the unemployment rates in the U.S. and Europe. The spread has been far less correlated to the difference in inflation rates between the two economies. Reported headline inflation in the U.S. is only 30bps above the same measure in Europe, with core inflation only 60bps higher in the U.S. (Chart 11). The latter may be more critical for the future direction of the Treasury-Bund spread, however. The dip in Euro Area core inflation back below the 1% level at the end of 2017 was a surprise given the strength of European growth last year, with real GDP reaching a well-above potential pace of 2.8%. Core inflation must rise from the current 0.9% level for the ECB to consider any move to a tighter monetary policy stance, as this would give the central bank confidence that its 2% inflation target would be reached in the medium-term. The markets seem to be pricing in a recovery of Euro Area core inflation in the coming months. Our Euro Area months-to-hike indicator, which measures the number of months until the first full 25bp rate hike is priced into the EUR Overnight Index Swap (OIS) curve, is now down to 17 months. As the interest rate markets have pulled forward the date of the next ECB rate hike to June 2019, the currency markets have followed suit with the euro rallying to a 3-year high last week (Chart 12). Chart 11Big Gaps Between Yields & Unemployment,##BR##Small Gaps In Inflation Chart 12Markets Are Acting Like##BR##Core Inflation Will Rebound In Europe A rebound in Euro Area core inflation is the first step towards seeing a convergence of the Treasury-Bund spread. The key is how the ECB responds to that move. Looking across the full spectrum of maturities, the moves in the yield gap between U.S. Treasuries and German government bonds have historically occurred alongside changes in relative inflation expectations (Chart 13). This makes sense, as to the extent that inflation expectations were climbing at a faster rate in the U.S. than in Europe, the market would price in a higher future Fed funds rate relative to European policy rates and, thus, widen the Treasury-Bund spread (and vice versa). That correlation between relative inflation expectations and the Treasury-Bund spread has broken down in recent years. The specific timing of that breakdown can be traced back to the August 2014 speech given by Mario Draghi at the Fed's Jackson Hole conference, marked by the vertical line in Chart 13. In that speech, Draghi introduced the idea that the ECB could begin buying government bonds to fight deflation pressures in Europe. That sent a powerful signal to the markets not to expect any movement in European policy rates for some time - the typical response seen in recent years to an announcement by a central bank that it was ramping up asset purchases. If Euro Area core inflation begins to rise in the coming months, the ECB's "forward guidance" can start to work in reverse. The ECB will be forced to signal further reductions in its asset purchases, likely all the way to zero in a full taper scenario. Markets will then begin to price in both higher inflation expectations and ECB rate hikes, resulting in a normalization of the Treasury-Bund spread through higher Bund yields. Until that inflation upturn happens in Europe, however, it will be difficult to get much of a tightening of the Treasury-Bund spread. In Chart 14, we present the spread versus the difference between policy rates in the U.S. and Europe (top panel), the ratio of the U.S. and Euro Area unemployment rates (middle panel), and the gap between U.S. and European headline inflation (bottom panel). At the moment, the Treasury-Bund spread is being held at an elevated level by the relative unemployment rates, with the spread looking wide versus the inflation differential. The much lower U.S. unemployment rate, which is driving the Fed to continue slowly hiking interest rates while the ECB keeps policy rates near zero, is preventing any meaningful decline in the Treasury-Bund spread. Chart 13UST-Bund Spread Has Divorced##BR##From Inflation During ECB QE Chart 14UST-Bund Spread Reflects Policy##BR##& Unemployment Differentials We have combined these three variables into a simple econometric model to explain the Treasury-Bund spread (Chart 15). We also added the size of the balance sheets of the Fed and ECB as separate variables, to account for the impact of bond purchases from each central bank. This model shows that a) the predicted value of the spread continues to steadily rise and b) the current spread is below one standard deviation away from that predicted value - a level equal to 237bps on the spread. That implies that there is still room for Treasury yields to climb higher versus Bunds before the spread becomes "too wide". Additional spread widening will be much harder to come by in the near-term, however. The gap between data surprise indices between the U.S. and Euro Area - which correlates well to the momentum in the Treasury-Bund spread - is relatively stretched, at a time when U.S. bond managers are already very underweight duration exposure (Chart 16). Yet with the forward curves already pricing in some mild tightening over the next year (top panel), betting on Treasury-Bund spread widening is a positive carry trade. One final point in favor of a wider Treasury-Bund spread is that the spread momentum is not yet close to the extremes seen in previous cycles (Chart 17). The big cyclical peaks in the spread typically occur when spreads are 50bps above the 200-day moving average, which is well above current levels. Chart 15Our New Model Suggests##BR##UST-Bund Spread Not Overstretched Chart 16Relative Data Surprises & UST##BR##Positioning May Limit Additional Spread Widening Chart 17UST-Bund Spread Momentum##BR##Not Yet At Stretched Extremes Our conclusion after looking at all these indicators is that the major cyclical peak in the Treasury-Bund spread is not yet on the immediate horizon, but is likely to unfold later this year - after one final move higher in Treasury yields versus Bunds. Bottom Line: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns