Europe
Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Chart I-5... And ##br##The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. 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-13 * 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 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. 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 Empirical evidence shows the clear existence of 'mini-cycles' - with the credit impulse and bond yield cycles 'out of phase' with each other by about 6 months. The credit impulse mini-cycle rolled over in October, suggesting that the bond yield mini-cycle will roll over in April. The bond yield mini-cycle is also approaching a technical limit. Hence, on a 3-month horizon, lean against the rise in bond yields and bank equities. And underweight the bank-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Feature The euro area's flash GDP print for Q4 confirms that the single-currency bloc has been one of the world's top-performing major economies through recent quarters. Furthermore, the latest inflation data confirm that euro area inflation is no different to other major economies when compared on an apples for apples basis - supporting our argument last week in Fake News In Europe.1 Having said that, the economy's latest 'mini-upswing' is likely approaching its end. And according to our framework, the euro area might not be alone in this experience. Mini-Cycles Everywhere Empirically, the economy exhibits very clear 'mini-cycles' whose upswings and downswings last 6-12 months. These economic mini-cycles overlay the much longer business cycle which lasts multiple years. Compelling evidence for these 6-12 month mini-cycles is everywhere. Just look at the credit impulse, the bond yield, commodity price inflation, or perhaps most fundamentally, GDP growth rates (Chart of the Week and Chart I-2, Chart I-3 and Chart I-4). Chart of the WeekThe 6-Month Credit Impulse Rolled Over In October Chart I-2Mini-Cycles In The Bond Yield Chart I-3Mini-Cycles In Commodity Price Inflation Chart I-4Mini-Cycles In 6-Month GDP Growth But bear in mind that to see any cycle it is crucial to focus on the right periodicity. If you look at a clock pendulum once every second, you will not see its cycle. The pendulum will appear motionless. Only when you look at the pendulum once every half-second will you see its regular cycle. Likewise, to see the economic mini-cycles you need to look at rates of change not over a year but over a half-year. The Economy: A Naturally-Oscillating System The economy's clear mini-cycles are the hallmark of any system that possesses two characteristics: Internal regulating feedback. Time delays in the system response to the feedback. As a familiar example, think of the thermostat that controls the central heating in your home. If there is a delay in the thermostat's response to a temperature setting of 20 degrees, the thermostat will switch the heating on and off slightly late. Which will cause the temperature to oscillate perpetually between 19 and 21 degrees, rather than to stay at a constant 20 degrees. A better example is the cruise control on your car. In the internal regulating feedback: the speed regulates the gas pedal; the gas pedal regulates the gasoline flow; the gasoline flow regulates the engine; and the engine regulates the speed. Assuming this internal regulating feedback works instantaneously from start to finish, the car will cruise at a constant 60 mph. But if there are delays in the system response, the speed will oscillate between, say, 58 mph and 62 mph. Now let's translate this to the economy with the following equivalences (Figure I-1): Speed = GDP growth data Gas pedal = Bond yield Gasoline flow = Credit flow Engine = Economy Figure I-1Internal Regulating Feedback + Time Delays = Mini-Cycles In the economy's internal regulating feedback: the GDP growth data regulates the bond yield; the bond yield regulates the credit flow; the credit flow regulates the economy; and the economy regulates the GDP growth data. But just like the cruise control, if there are delays in the system response, the economy will exhibit oscillations. Crucially, there are delays in the economic system response. For a change in the bond yield to register with households and firms and fully impact credit flows, it clearly takes time - empirically in the range of 3-9 months. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows takes time - again empirically in the range of 3-9 months. Once you accept these assumptions of internal regulating feedback combined with clear delays in economic response, the economy has to be a naturally-oscillating system. For those who are mathematically inclined, Box I-1 shows how to derive the differential equation of the economic mini-cycle using first principles. Box I-1The Mathematics Of Mini-Cycles From Theory To Practice So much for the elegant theory, does it actually work? The real economy is complicated by other factors which can stretch and distort the theory. Specifically, aggressive and experimental policy from central banks can cause bond yields to overshoot or undershoot fundamentals. Financial or political shocks can depress animal spirits or, as we have just seen, make them euphoric. A flight to or from safety can distort both bond yields and short-term economic activity. These distortive overlays can shorten or extend the amplitude and/or duration of a mini-cycle. So each mini-cycle is slightly different in size and length from its predecessor. The distortions also explain how a mini-upswing or mini-downswing can become amplified into a boom or recession. The analogy would be a car's cruise control trying to slow the speed to 60 mph whilst also coping with a very steep hill and gale-force headwind. Quite likely, the speed would slow to well below 60 mph. For the past 10 years, aggressive monetary policy shifts, financial shocks and political shocks have been a regular distortive feature of the economic landscape. Yet Chart I-5 clearly shows that 6-12 month mini-upswings and mini-downswings have existed with remarkable consistency and durability through the whole period. Chart I-5The Credit Impulse And Bond Yield Cycles Are 'Out Of Phase' By About 6 Months The empirical evidence shows the clear existence of mini-cycles - with the credit impulse and bond yield cycles 'out of phase' by about 6 months, exactly in line with theory. What Does This Mean For European Investors? The credit impulse mini-cycle rolled over in October. Using the average 6-month lag, this means that the bond yield mini-cycle should roll over in April. However, the current cycle could have a slightly shorter lag or a slightly longer lag than the average cycle. So today, we are delighted to introduce a new piece of proprietary analysis. For the bond yield itself, we can independently assess the extent of groupthink in its recent trend, and how close that is to its limit. Previously, we have done this using its 65-day (3-month) fractal dimension.2 But given that mini-cycle upswings and downswings average 6 months, it is more logical to use a 130-day (6-month) fractal dimension. As readers can see in Chart I-6, this indicator has an excellent track-record in identifying mini-cycle turning points. And it is now signalling that the current trend is reaching its technical limit. Chart I-6A Near-Perfect Indicator For Bond Market Turning Points Bottom Line: On a 3-month horizon, lean against the rise in bond yields3 and bank equities. And underweight the financial-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report, titled "The Use And Abuse Of Liquidity", June 9, 2016 available at eis.bcaresearch.com 3 The house view is tactically below benchmark duration Fractal Trading Model* Pleasingly, both of our most recent trades: short MIB/long Hang Seng and long NOK/RUB hit their profit targets in classic liquidity triggered trend-reversals. This week's trade is to go short Basic Materials equities. 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-7 * 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 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. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... Chart 6... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.
Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In January, the model outperformed global equities and the S&P 500 in USD terms, but underperformed in local-currency terms. For February, the model cut its weighting in stocks and increased its allocation to bonds (Chart 1). Within the equity portfolio, the weightings to both the U.S. and emerging markets were decreased. The model boosted its allocation to French bonds at the expense of Swedish and Canadian paper. The risk index for stocks, as well as the one for bonds, deteriorated in January. Feature Performance In January, the recommended balanced portfolio gained 1.4% in local-currency terms, and 3.6% in U.S. dollar terms (Chart 2). This compares with a gain of 3.2% for the global equity benchmark and a 2% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The performance of bonds was a detractor from the model's performance in local currency terms in January. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model decreased its allocation to stocks from 57% to 53%, and upgraded its bond weighting from 43% to 47% (Table 1). Table 1Model Weights (As Of January 26, 2017) The model increased its equity allocation to France, Italy, and Sweden by one point each. Meanwhile, weightings were cut by 2 points in the U.S., and by 1 point in Germany, Spain, Switzerland, Emerging Asia, and Latin America. In the fixed-income space, the allocation to French paper was increased by 6 points and the U.K. by 1 point. The model cut its exposure to Swedish bonds by 2 points and Canadian bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time we do provide our recommendations. The dollar weakened in January and our Dollar Capitulation Index fell close to neutral levels. Uncertainty over the size of the fiscal push by the U.S. administration could prolong the dollar's consolidation phase, especially if coupled with any negative economic surprises. However, this would only be a pause since continued monetary policy divergence should translate into another leg up in the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The deterioration of the value and cyclical components led to a higher risk index for commodities. The model continues to shun this asset class (Chart 4). The risk index for global equities increased to a 3-year high in January due to the deterioration in the value indicator. While the global risk index for global bonds also deteriorated, it remains firmly in the low-risk zone. The model slightly decreased its allocation in equities to the benefit of bonds (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk Following the latest uptick in the risk index for U.S. equities, the allocation to this asset class was trimmed. U.S. stocks have been propped up by the growth-positive aspects of the new U.S. administration's policies and are at risk should this optimism deflate (Chart 6). The risk index for Canadian equities improved slightly in January as the better readings in the liquidity and momentum indicators offset continued worsening in value. That said, the overall risk index remains at the highest level in this business cycle. This asset remains excluded from the portfolio (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Canadian Stock Market And Risk The risk index for U.K. equities deteriorated, reaching a post-Brexit high. For the first time in over two years, the value component crossed into expensive territory (Chart 8) The model trimmed its allocation to Emerging Asian stocks following the slight uptick in the risk index. While the global reflationary pulse should bode well for this asset class, rumblings about protectionism threaten to de-rate growth expectations (Chart 9). Chart 8U.K. Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk The unwinding of oversold conditions was the main reason behind the deterioration in the risk index for bonds in January. However, the latter is still in the low-risk zone as the bond-negative reading from the cyclical indicator remains overshadowed by the ongoing oversold conditions in the momentum indicator (Chart 10). The risk index for U.S. Treasurys deteriorated in January on the back of a less-stretched momentum indicator. While the cyclical backdrop is bond-bearish, there is arguably more room for scaling down optimism over the economy than there is to having an even more upbeat outlook. As a result, any resumption of the rise in Treasury yields could end up being very gradual (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The risk index for euro area government bonds also deteriorated in January, but unlike the U.S., it is in the high-risk zone. There are notable differences in the risk readings within euro area markets (Chart 12). Given the upcoming presidential elections, France is next in line in terms of investors' focus on political risks. French bonds are heavily oversold based on the momentum indicator, pushing the overall risk index lower. An unwinding of the risk premium would bode well for French bonds, which the model upgraded in January (Chart 13). Chart 12Euro Area Bond Yields And Risk Chart 13French Bond Yields And Risk The risk index for Spanish government bonds ticked down slightly reflecting minor improvements in all three of its components. However, it remains much higher than the risk index for the French paper, which is preferred by the model (Chart 14). With the risk index little changed in January, Swiss government bonds remain in the high-risk zone. The model continues avoiding this asset which possesses negative yields (Chart 15). Chart 14Spanish Bond Yields And Risk Chart 15Swiss Bond Yields And Risk Currency Technicals The dollar depreciated after the 13-week momentum measure indicated last month that the greenback could face near-term resistance. Further consolidation cannot be ruled out, but the 40-week rate of change measure is not signaling an end to the dollar bull market. The monetary policy divergence between the Fed and its peers provides underlying support for the dollar, while heightened uncertainty on the fiscal front implies more volatility going forward (Chart 16). EUR/USD was not able to stay below 1.05. The short-term rate-of-change measure is approaching neutral levels, which could test the EUR/USD bounce. A risk-off episode or continued solid economic data are two factors that could provide some support for the euro in the near term (Chart 17). The 40-week rate of change measure for GBP/USD continues to hover near the most oversold level since 2000 (excluding the great recession). Meanwhile, the 13-week momentum measure crossed into positive territory, but is not extended. The pound will remain event-driven and possibly range-bound in the near term as the mood bounces within the hard Brexit / soft Brexit spectrum (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Euro Chart 18Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * 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 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. 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-7Indicators To Watch##br## - Interest Rate Expectations