Europe
Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. 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-9 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 A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Nonetheless, we have not changed our recommended asset allocation. Bond markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. We do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. Oil prices should rebound, based on our view that consumption will outstrip production in the second half of the year; the surprise will be how strong oil prices are in the coming months. The FOMC appears more determined than in the past to stick with the current policy normalization timetable. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. We believe that the labor market is tight enough to gradually push up inflation. Together with a rebound in the commodity pits, this means that the recent bond rally will reverse. Soft U.S. CPI readings are a challenge to our view. The Fed will delay the next rate hike into next year if core inflation does not move up in the next few months. The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided leading information in the past are warning of an equity bear market. The profit backdrop remains constructive. Our base case is that stocks beat bonds and cash for the remainder of 2017. We expect to trim exposure to equities next year, but the evolution of a number of indicators will influence the timing. The same is true for corporate bonds. The dollar's bull phase has one more upleg left. Japanese, European and U.K. equities will outperform the U.S. in local currency terms. Feature A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Investors quickly concluded that the Fed will have to proceed even more slowly in terms of its policy normalization plan which, in turn, sent the dollar and global bond yields sharply lower. Equity indexes held up because of the dollar and bond yield "relief valves". Stocks are also benefiting from the continuing rebound in corporate earnings growth in the major economies. Nonetheless, the commodity pullback and soft U.S. inflation data are a challenge to our reflation theme, which includes a final upleg in the U.S. dollar and a negative view on bond prices. We believe that markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. We also think that the FOMC is more determined than in the past to stick with the current policy normalization timetable. The bottom line is that we are not changing our recommended asset allocation based on June's market action. We remain overweight stocks and corporate bonds relative to government bonds and cash. We are also short duration and long the dollar. A key risk to our asset allocation relates to our contrarily bullish view on oil prices. Oil Drove The Bond Rally... The decline in long-term bond yields since March reflected in large part a drop in inflation expectations (Chart I-1). BCA's fixed-income strategists point out that the slump in long-term inflation expectations has been widespread across the major countries, irrespective of whether actual inflation is trending up or down.1 Core inflation has moved lower in the U.S., Japan, Canada and (slightly) in the Eurozone, but has increased in Australia and the U.K. In terms of diffusion indexes, which often lead core inflation, they are falling in the U.S., Japan and Canada, but are rising in the U.K., the Eurozone and Australia (Chart I-2). Chart I-1 Inflation Expectations Drive Bond Rally Chart I-2Diverging Inflation Trends Given all these diverging signals within the national inflation data, it is odd that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the commodity price decline as the main driver of the downshift in expectations. Short-term moves in oil prices should not affect long-term inflation expectations, but in practice the correlation has been strong since the plunge in oil prices beginning in 2014. Weaker oil and other commodity prices have also fed investor concerns that global growth is waning. We see little evidence of any slowdown in global growth, although some leading indicators have softened. Key monthly data such as industrial production, retail sales and capital goods orders reveal an acceleration in growth for the advanced economies as a group (Chart I-3). There has also been a general upgrading of the consensus growth forecast for the major countries and for the world in both 2017 and 2018 (Chart I-4). This is unlike previous years, when growth forecasts started the year high, only to be slashed as the year progressed. Chart I-3No Slowdown In Advanced Economies Chart I-4Growth Expectations Revised Up ...But Watch Out For A Reversal The implication is that we do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Nonetheless, the mini oil meltdown in June went against our medium-term bullish view. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not yet see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue will prevail in the coming months. Chart I-5Falling Inventories To Drive Oil Rebound The investment community is being overly pessimistic in our view. The coalition led by the Saudi Arabia and Russia will have removed 1.4 MMB/d of production on average from the market between January 2017 and end-March 2018, versus peak production in November of last year. This will be diluted somewhat by the Libyan and U.S. production gains, but the increased production will not be sufficient to counter the OPEC/Russia cuts entirely. We expect global production to increase by only 0.7 MMB/d in 2017, an estimate that includes rapid increases in U.S. shale output. Meanwhile, we expect consumption to grow by 1.5 MMB/d, implying that oil inventories will fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart I-5). It will be quite a shock to markets if crude reaches $60/bbl by December as we expect. As for base metals, it appears that the correction is largely related to reduced speculative demand rather than weak global and/or Chinese demand. It is true that the Chinese economy has slipped a notch according to some measures, such as housing starts and M2 growth. Nonetheless, the government remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system in June and fiscal policy has been eased. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Retail sales continue to expand at a healthy clip. Export growth is accelerating thanks to a weaker currency and stronger global activity. Given that many investors remain concerned about a hard landing in China, the bar for positive surprises is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the commodity currencies and other commodity plays. A rebound in base metal and, especially, oil prices would boost global inflation expectations and bond yields, especially since inflation expectations have fallen too far relative to underlying non-energy inflation pressures. This forecast also applies to the U.S. bond market, although there was more to the soft May CPI report than oil prices. Is The Fed's Inflation Target Credible? Investors are questioning whether the Fed has the ability to reach its inflation goals. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? We argued above that the moderation in inflation expectations in the major markets was mostly related to the decline in commodity prices. However, in the U.S., it also reflected a fairly widespread pullback in CPI inflation this year. This is contrary to Fed Chair Yellen's assertion that most of it reflects special factors such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The three-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial at 2.8 percentage points. Table I-1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table I-1Key Drivers Of U.S. Core Inflation Deceleration In 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the dollar or on-line shopping, is worrying. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data are published almost a month behind the CPI data. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart I-6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart I-7). The slowdown has been fairly widespread across manufacturing and services. However, the soft patch already appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart I-8). The ECI is adjusted to avoid compositional effects that can distort the aggregate index. The related diffusion indexes also remain constructive. Chart I-6PCE Inflation Rate To Follow CPI Lower Chart I-7AHE SoftPatch Appears Over... Chart I-8...And The ECI Marches Higher We conclude from these and other wage measures that the Phillips curve is still operating in the U.S. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even with a tight labor market. Nonetheless, the relationship between the ECI and various measures of labor market tightness shown in Chart I-8 does not appear to have broken down. The percentage of U.S. states with unemployment below the Fed's estimate of full employment jumped to 70% in May. Anything over 60% in the past has been associated with wage pressure (Chart I-9). The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed hawks that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart I-10). Admittedly, however, the U.S. inflation reports in the coming months are a key risk to our reflation-related asset allocation. Chart I-9More Than 70% Of U.S. States Have Excess Labor Demand Chart I-10Financial Conditions Point To Faster Growth And Inflation What Will The Fed Do? The CPI data have certainly rattled some members of the FOMC. Federal Reserve Bank Presidents Kaplan and Kashkari, for example, believe that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. She stressed that the FOMC makes policy for the "medium term," and should not over-react to short-term wiggles in the data. Vice President Dudley echoed this view in recent comments he made to the press. The Fed has been quick to back away from planned rate hikes at the first hint of trouble in recent years. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further, despite the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve budding inflation pressure; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will build if the low-rate environment extends much further. The bottom line is that we expect the Fed to stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? We see three possible scenarios for the bond market: Reflation Returns: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would begin to discount a "policy mistake" scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of probabilities, we would characterize Scenario 1 as our base case, Scenario 2 as unlikely and Scenario 3 as a tail risk. We remain short-duration in anticipation of a rebound in long-term inflation expectations and higher yields. A bond selloff, however, should not present a major headwind for stocks as long as the earnings backdrop remains constructive. Will The Real Profit Margin Please Stand Up For some time we have been highlighting the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of somewhat stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, however, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in big trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.3 Nonetheless, we can make some general observations. Chart I-11 presents the 4-quarter growth rate of NIPA profits4 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart I-11 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that, while there have been marked differences in annual growth rates between the two measures in some years, the levels ended up being close to the same point in the first quarter of 2017. The dip in NIPA profit growth in the first quarter was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. That said, broadly speaking, it does not appear that the difference in margins is due to a significant divergence in aggregate profits. It turns out that most of the margin divergence is related to the denominator of the calculation (Chart I-12). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is quite different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. It appears to us that the S&P data are telling the correct story at the moment. After all, sales are straight forward to measure, while value added is complicated to construct. The fact that sales are growing slowly is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are signaling strong profit growth when the reality is the opposite. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a large part of this year's U.S. equity market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery (Chart I-13). The proportion of S&P industry groups with rising earnings estimates is above 75%. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Chart I-11S&P And NIPA Profit Comparison Chart I-12Denominator Explains S&P/NIPA Margin Divergence Chart I-13Positive Earnings Revisions Are Broadly Based The solid earnings backdrop is the main reason we remain overweight stocks versus bonds and cash. Of course, given poor valuation, we must be extra vigilant in watching for warning signs of a bear market. Valuation has never been good leading indicator for bear markets, but it does provide information on the risks. Monitoring The Bear Market Barometer BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report.5 He noted that no two bear markets are the same, and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, there is not extreme overvaluation, and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart I-14: Chart I-14Equity Bear Market Indicators Monetary Conditions: The yield curve is quite flat by historical standards, but it is far from inverting. Moreover, real short-term interest rates are normally substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is because of the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is quite stretched. Economic Outlook: Economic data such as the leading economic indicator and ISM have been unreliable bear market signals. That said, we do not see anything that suggests that a recession is on the horizon. Indeed, U.S. growth is likely to remain above-trend in the second half of the year based on its relationship with financial conditions. Technical conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40-week moving average, and our composite technical indicator are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it has been a bad sign when EPS growth topped out. And this has often been preceded by a peak in industrial production growth. We expect U.S. EPS growth to continue to accelerate for at least a few more months, but are watching industrial production closely. EPS growth in Japan and the Eurozone will likely peak after the U.S., since these markets are not as advanced in the profit rebound. The bottom line is that the equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided some leading information in the past are warning of an equity bear market. Investment Conclusions The major world bourses remain in a sweet spot because of the mini cyclical rebound in profits. One can imagine many scenarios in which equities suffer a major correction or bear phase. However, stocks would likely perform well under the two most likely scenarios for the remainder of the year. If U.S. and global growth disappoint, the combination of low bond yields and still-robust earnings growth will continue to support prices. Conversely, if world growth remains solid and the U.S. picks up, as we expect, then bond yields will rise but investors will pencil-in an even stronger profit advance over the next year. Of course, this win-win situation for stocks will not last forever. Perhaps paradoxically, the economic cycle could be shortened if the U.S. Congress gets around to passing a bill that imparts fiscal stimulus in 2018. The Fed would have to respond with a more aggressive tightening timetable, setting the stage for the next recession. In contrast, the economic cycle would be further stretched out in the absence of fiscal stimulus, keeping alive for a while longer the lackluster growth/low inflation/low bond yield backdrop that has been favorable for the equity market. We are watching the indicators discussed above to time the exit from our pro-risk asset allocation that favors stocks and corporate bonds to government bonds and cash. As for the duration call, the whiff of deflation that has depressed bond yields over the past month is overdone. Investors have also become too complacent on the Fed. We expect that the recent drop in commodity prices, especially oil, will reverse. If this view is correct, it means that the cyclical bull phase in the dollar is not over because market expectations for the pace of Fed rate hikes will rise relative to expectations in the other major economies (with the exception of Canada). We are still looking for a 10% dollar appreciation. It also means that Treasurys will underperform JGBs and Bunds within currency-hedged fixed-income portfolios. We expect the Eurostoxx 600 and the Nikkei indexes to outperform the S&P 500 this year in local currencies, despite our constructive view on U.S. growth. Stocks are cheaper in the former two markets. Moreover, both Japan and the Eurozone are earlier in the profit mini-cycle, which means that there is room for catch-up versus the U.S. over the next 6-12 months when growth in the latter tops-out. The prospect of structural reform in France is also constructive for European stocks, following the election of a reformist legislature in June. However, the upcoming Italian election warrants close scrutiny. The key risk to this base case is our view that oil prices will rebound. This is clearly a non-consensus call. If OPEC production cuts are unable to overwhelm the rise in U.S. shale output, then inventories will remain elevated and oil prices could move even lower in the near term. Our bullish equity view would be fine in this case, but the bond bear market and dollar appreciation we expect would at least be delayed. Finally, a few words on the U.K. Our geopolitical experts highlight two key points related to June's election outcome: fiscal austerity is dead and the U.K. will pursue a "softer" variety of Brexit. This combination should provide a relatively benign backdrop for U.K. stocks and the economy over the next year. Nonetheless, the cloud of uncertainty hanging over the U.K. is large enough to keep the Bank of England (BoE) on hold. Some BoE hawks are agitating for tighter policy due to the worsening inflation overshoot, but it will probably be some time before the consensus on the Monetary Policy Committee shifts in favor of rate hikes. This means that it is too early to position for gilt underperformance within fixed-income portfolios. Sterling weakness looks overdone, although we do not see much upside either. As long as Brexit talks do not become acrimonious (which is our view), the U.K. stock market should be one of the outperformers in local currency terms among the major developed markets. Mark McClellan Senior Vice President The Bank Credit Analyst June 29, 2017 Next Report: July 27, 2017 1 For more discussion, see Alternative Facts in the Bond Market at BCA Global Fixed Income Strategy Weekly Report, dated June 13, 2017 available at gfis.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "Views from the Road," dated June 21, 2017, available at nrg.bcaresearch.com 3 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 4 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 5 Please see BCA Special Report "Timing The Next Equity Bear Market," dated January 24, 2014, available at bcaresearch.com II. Preferences As Trading Constraints: A New Asset Allocation Indicator Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity Chart II-3Revealing What Investors Prefer Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... Chart II-8B...As Well As Other Indicators Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance. III. Indicators And Reference Charts Thanks to the recent dollar and bond yield “relief valves”, the S&P 500 is stubbornly holding above the 2,400 level. The breakout above this level further stretched valuation metrics. Measures such as the Shiller P/E and price/book are at post tech-bubble highs. Stocks remain expensive based on our composite Valuation Index, although it is still shy of the +1 standard deviation level that demarcates over-valuation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, once interest rate normalization is well underway, these indicator will not look as favorable. It is good news for the equity market that our Monetary Indicator did not move further into negative territory over the past month. Indeed, the indicator has hooked up slightly and is sitting close to a neutral level. Our equity Technical Indicator remains constructive. Other measures, such as our Speculation Index, composite sentiment and the VIX suggest that equity investors are overly bullish from a contrary perspective. On the other hand, the U.S. earnings surprises diffusion index highlights that upside earnings surprises are broadly based. Our elevated U.S. Willingness-to-Pay (WTP) indicator ticked down from a high level this month, suggesting that ‘dry powder’ available to buy this market is depleted. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. The pull back in long-term bond yields since March was enough to “move the dial” in terms of the bond valuation or technical indicators. U.S. bond valuation has inched lower to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. We also think that the FOMC is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment, which support our negative view on bond prices. Now that oversold technical conditions have been unwound, it suggests that the consolidation phase for bond yields is largely complete. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, it is a bearish sign that the dollar moved lower and crossed its 200-day moving average. However, our Composite Technical Indicator highlights that overbought conditions have been worked off. We still believe the U.S. dollar’s bull phase has one more upleg left. Technical conditions are also benign in the commodity complex. Most commodities have shifted down over the last month to meet support at their 200-day moving averages. Base metals are due for a bounce, but we are most bullish on oil. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Chart III-19Euro Technicals Chart III-20Euro/Yen Technicals Chart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China
Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - 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 (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. 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-17 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