Financial Markets
While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.
Highlights We were on the road last week, discussing our economic and market outlooks: We met with a range of Midwestern clients who focus primarily on the U.S. A majority of our meetings were with fixed-income teams. The Fed will ultimately decide the fate of the expansion, … : Nearly everyone wanted to get a read on how much longer the expansion will last. We offered the view that the Fed will induce the next recession, provided that an exogenous event doesn’t beat it to the punch. … and inflation will be the catalyst that prompts the Fed to act: Inflation was typically far from investors’ minds, and several of our meetings centered on what will drive it, and where and when we expect it will show up. Feature We traveled throughout the Midwest last week, discussing our outlook for financial markets and the economy with a range of investors. We got the sense that our clients are constructive about the economy and are generally open to tilting portfolios in a risk-friendly direction, albeit somewhat grudgingly. They recognized the challenge that worsening U.S.-China trade relations would pose to a constructive call, but were content to wait for more information before adjusting their views or their portfolios. Our views continue to follow the outline we’ve laid out in our written reports. In the absence of economic or financial market excesses, or an exogenous shock that induces a material slowdown, we expect the expansion to roll on until the Fed begins to fear that it’s gone too far and imposes restrictive monetary policy settings to rein it in. Until it does, we expect that the equity bull market will continue and spread product will deliver positive excess returns over Treasuries. The investment strategy takeaway is that it is too early to de-risk portfolios. De-risking will become the order of the day once the Fed resumes tightening monetary conditions via rate hikes. There is currently no sign that the Fed is contemplating a meaningfully hawkish shift, but we expect that inflation pressures will eventually force its hand. Ten years of subdued inflation have made a mockery of recurring post-crisis inflation warnings, and clients have developed a robust immunity to them. What, they wanted to know, has changed enough to resuscitate inflation? Steroid-Fueled Demand Aggregate demand crashed during the crisis and was far short of the economy’s capacity when it bottomed in mid-2009. In economics lingo, that meant that the U.S. economy faced a sizable negative output gap when it embarked on the recovery/expansion. Although the economy grew at a tepid 2% rate over the ensuing decade, capacity grew even more slowly, held back by consistently weak capital expenditures, and the output gap finally closed around the beginning of 2018 (Chart 1), removing a stout inflation-absorbing buffer. Chart 1The Excess Capacity Cushion Is Gone The United States then poured fuel on the fire by injecting a significant quantity of stimulus into an economy that was already operating at capacity. Corporations and other businesses that viewed the pickup in aggregate demand as a one-off event refrained from expanding capacity to meet that demand, as it appeared as if it would be a poor use of capital. Imported goods from economies that still have excess capacity can relieve some of the pressure of inadequate domestic supply, but they’re unlikely to absorb all of the pressure from excess demand, even in the absence of new tariff barriers. The aggregate 2018-19 stimulus shapes up as a catalyst for higher prices. Capacity vastly exceeded demand when the economy began to turn around ten years ago, but the stimulus package has made it look a little thin. The trouble is that no one can pinpoint exactly when upward price pressures will reveal themselves. Inflation is the mother of all lagging indicators, peaking and bottoming well after business cycle transitions suggest it should (Chart 2). All we can say is that the steroid injection from the stimulus planted the seeds of inflation. Just when they’ll begin to sprout is uncertain, but we believe the Fed’s pause will give them a chance to take root. Wage Inflation The labor market is so tight that it squeaks. The unemployment rate has fallen to a 49-year low; baby boomer retirements will cap the labor force participation rate around its current level (Chart 3, top panel); and discouraged workers (Chart 3, middle panel) and involuntary part-time workers are few and far between (Chart 3, bottom panel). Now that it has been absorbed, the glut of idled workers will no longer serve as a buffer neutralizing upward wage pressures. The labor market is tight as a drum. The pool of discouraged workers and involuntary part-timers is smaller than it was at the last two cyclical peaks, while employer demand is more robust. Employees are starting to gain bargaining power. The Job Openings and Labor Turnover Survey (JOLTS) indicates that demand for new workers is intense. As a share of total filled positions, job openings are at an all-time high in the 18-year history of the series (Chart 4, middle panel). No one quits a job unless s/he has another one lined up, and it almost always requires higher pay to induce an employee to jump from Employer A to Employer B. The elevated quit rate thus reveals that employers are poaching workers from each other to meet that demand (Chart 4, bottom panel). After Employer B lures an employee away from Employer A, Employer A hires a worker from Employer C or Employer D, which now has an opening it needs to fill. The employment merry-go-round creates a self-reinforcing cycle pushing wages higher and endowing employees with newfound bargaining power. Chart 3With Fewer Workers On The Sidelines … Chart 4… Employers Have Turned To Poaching Self-sustaining wage gains could produce price-level increases via a demand-pull or a cost-push mechanism. In a demand-pull framework, businesses observing steady payroll expansions and increased household income may well attempt to push through selling price increases. Under cost-push, corporations raise prices in an attempt to offset increased labor costs. Then again, the pass-through from wage inflation to price inflation might not occur at all, as the dynamics of inflation are not fully understood. What The Fed Believes Investors may be frustrated by the lack of a clear connection between wages and prices, but they should not be put off by a little ambiguity – there would be no alpha without uncertainty. An absence of realized inflation does not eliminate the prospect of rate hikes. Our Inflation → Rate Hikes → Restrictive Monetary Policy → Recession → Bear Market roadmap may still come to pass. The first step in the chain would simply have to be perceived inflation as opposed to realized inflation, and it’s the Fed’s perception that drives monetary policy, not the public’s. As we stressed in our Special Report on the Phillips curve,1 there is no alternative explanation in mainstream economics connecting the dots between the elements of the Fed’s dual mandate. Every mainstream economic model posits an inverse relationship between inflation and the unemployment rate. Every economist learned about the expectations-augmented Phillips curve multiple times in the course of his or her undergraduate and graduate studies. Until the profession settles on an alternative narrative, the Fed and other major central banks will be beholden to the Phillips curve. The connection between wages and prices is a mystery, but the Phillips curve’s place in mainstream economics remains secure. It’s easy to talk of patience when inflation has been hibernating for ten years, even with the unemployment rate at 49-year lows, but once wage gains begin to exceed 3.5% and 4%, we expect the Fed will change its tune. Wages do not respond to changes in the unemployment rate when there’s ample slack in the labor market, but they do once it becomes difficult to find employees. The varying sensitivity of changes in wages at different levels of unemployment explains the kink in the Phillips curve, but we found the NAIRU-based unemployment gap2 to be a reliable proxy for identifying the point at which the labor market meaningfully tightens (Chart 5). Chart 5NAIRU, … The natural rate of unemployment is only a concept, however, and the CBO series we use to calculate the unemployment gap is subject to retroactive adjustments intended to better match the CBO’s estimates with real-world observations. We therefore incorporated two alternative measures of labor market slack to test the robustness of the unemployment-gap framework. The first is the Jobs Plentiful/Jobs Hard To Get responses from the Conference Board’s consumer confidence survey. The top panel of Chart 6 calculates the difference between Jobs Hard To Get and Jobs Plentiful; when it’s positive (negative), survey respondents are indicating that the labor market is soft (tight). The disparity in wage growth between the soft and the tight states, as estimated by the hoi polloi, is a little larger than under the CBO’s revised NAIRU estimates, suggesting Main Street may be better positioned to evaluate labor-market dynamics than D Street (the CBO’s address). Chart 6… The Consumer Confidence Survey, … To get away from the arbitrariness of the unemployment rate and the uncertainty of NAIRU estimates, we considered the employment gap from the perspective of the prime-age (non-)employment-to-population ratio (Chart 7). It also supports the conclusion that wage gains are a function of the degree of labor market slack, but the outlier results from the crisis render the mean non-employment ratio since 1985 a less-than-perfect boundary between tightness and slack. The prime-age (non-)employment-to-population ratio better fits the standard Phillips curve framework, producing a solidly linear relationship (Chart 8). It points to further wage gains as prime-age employment increases. Chart 7… And Prime-Age (Non-)Employment All Point To Faster Wage Gains If productivity continues to grow by leaps and bounds – the fourth-quarter gain was impressive, the first-quarter’s was eye-popping – the Fed won’t feel much pressure to hike rates. Productivity is a function of capital expenditures; workers are able to increase output when they’re provided with more and better tools. Capex has been extremely weak ever since the crisis in the U.S. and the rest of the world, however, and we do not think that investors should count on productivity remaining much above its low 1%-plus trend level of the last several years. Investment Implications The ultimate effect of the Fed’s pause will be to extend the duration of the expansion, assuming that an exogenous shock does not pull the plug on it. Extending the expansion will have the effect of extending the equity bull market, and the period in which spread product generates positive excess returns over Treasuries. There is no free lunch, and dovishness now will be offset by hawkishness later. Larger bull-market gains will ultimately be countered by larger bear-market losses. That is a concern for another day, however, and we continue to recommend that investors remain at least equal weight equities and spread product in balanced portfolios. We do not see a recession until the second half of 2020 at the earliest. Our best guess is that it will begin around the middle of 2021, so it is too early to de-risk portfolios or shift to a more defensive asset allocation profile. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the U.S. Investment Strategy Special Report, “The Phillips Curve: Science Or Superstition?”, published February 26, 2019. Available at usis.bcaresearch.com. 2 The unemployment gap in the top panel of Chart 5 is calculated by subtracting the Congressional Budget Office’s estimate of NAIRU from the official unemployment rate. NAIRU, or the natural rate of unemployment (u*), is the minimum unemployment rate that would exist even in a full-employment economy. It results from structural factors like skill and geographic mismatches. The CBO currently estimates that NAIRU is 4.7%; the Fed’s dots suggest that it estimates u* is around 4.6%.
Highlights Portfolio Strategy Firming relative demand and input cost dynamics, the Medicare For All (MFA)-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short home improvement retail pair trade is in the early innings. Recent Changes Initiate a long S&P managed health care/short S&P semiconductors trade today, with a tight stop loss at -7%. Table 1 Feature Equities hit a speed bump last week, as President Trump’s trade related tweets instilled some fear back into the markets. Investor complacency reigned supreme and, given the liquidity crunch, risk premia exploded higher with the VIX more than doubling from the recent lows. Historically, a parabolic rise in policy uncertainty is synonymous with an equity market selloff and a widening in risk premia; last week was no different (economic policy uncertainty shown inverted, second panel, Chart 1). Adding insult to injury, given that the forward P/E multiple expansion explained all of the equity market’s advance year-to-date as we highlighted three weeks ago, the trade-related melt up in policy uncertainty caused a mini meltdown in the forward multiple as financial conditions tightened (financial conditions shown inverted, third panel, Chart 1). The implication is that short-term equity market caution is still warranted as we have been writing over the past few weeks, at least until the U.S./China trade dispute dust settles. Chart 1Caution Still Warranted Chart 2Tenuous Trio The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap (Chart 2). One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year. Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. Importantly, the 12-month forward EPS number is artificially rising. Chart 3 shows that calendar 2019 and 2020 EPS estimates continue to build a base, but the 12-month forward number has been rising since early-February. What explains the increase in the 12-month forward estimate is arithmetic. In other words, despite a multi-month downgrading of calendar 2019 and 2020 EPS, the first two quarters of next year are forecast to come in significantly higher than 2019’s first six months. As the latter roll off and the former get added to the 12-month forward EPS number, a deceiving jump occurs. For next year, we continue to expect $181 EPS, and we would lean against the double-digit EPS growth in 2020 that the sell-side currently forecasts. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth (Chart 4). Chart 3Artificial EPS Rise Chart 4SPX Macro EPS Model Forecasts Softness Finally, one of the tech sector’s invincible subgroups is cracking with the S&P semis relative performance hitting a wall both versus the broad market ex-TMT and versus the NASDAQ 100. This is significant not only from a sentiment perspective, but also because semis have high international sales exposure in general and China in particular (Chart 5). Chart 5Vertigo Warning This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. New High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date (Chart 6). This is an exploitable gap and today we suggest a new pair trade: long S&P managed health care/short S&P semiconductors. Chart 6Exploitable Reversal Looms Bernie Sanders’ revamped MFA bill sent the managed health care group to the ER. While there is heightened uncertainty surrounding MFA and we are working on a joint Special Report with our sister Geopolitical Strategy service due on June 3rd, this is likely a 2022 story. Not only will Sanders have to win the Democratic candidacy and subsequently the Presidential election, but also the GOP would have to lose the Senate. This is an extremely low probability event that has dealt a massive blow to HMO stocks. On the flip side, semis are priced for perfection. The recent catalyst for this group’s stratospheric rise was Apple’s patent settlement with Qualcomm that set in motion a 5G-related euphoria. Again 5G is a late-2021 story and a lot of good news is already priced in to semis stocks. Moreover, historically, semi cycles last four-to-five quarters and investors’ neglect of the semi downcycle is puzzling as we have recently concluded just two down quarters. Explicitly, what is truly baffling is that 12-month forward EPS are slated to contract in absolute terms and forward sales are hovering near the zero line, yet the Philly SOX index recently vaulted to all-time highs. Taken together, we would lean toward health care insurers at the expense of semiconductor stocks. Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. Chart 7 shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings. The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues. Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices. On all three fronts, the message is to expect a mean reversion higher in the relative share price ratio. Chart 7Buy Managed Health Care… Chart 8…At The Expense… Input cost/inventory dynamics suggest that HMOs also have the advantage. The health care insurance employment cost index is growing on a par with inflation, but semi industry employment is climbing at a rate over 5%/annum (bottom panel, Chart 8). Taking stock of medical cost inflation, costs are still melting, however global semi inventories are expanding. The upshot is that relative share prices have ample upside (middle panel, Chart 8). Finally, the previous relative valuation overshoot has returned to the neutral zone and, encouragingly, relative technicals are probing multi-year lows near one standard deviation below the historical mean. Importantly, over the past two decades every time our Technical Indicator has hit such a depressed level, a playable rebound in relative share prices has ensued (bottom panel, Chart 9). Chart 9…Of… Chart 10…Semis Nevertheless, this highly volatile market-neutral trade faces one big risk we previously alluded to: relative profit expectations are extended. In other words, the bombed out S&P semiconductor forward EPS and revenue projections are masking the relative profit and revenue backdrop (Chart 10). Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Bottom Line: Initiate a long S&P managed health care/short S&P semis pair trade today with a stop loss at the -7% mark. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively. Homebuilding/Home Improvement Retail Pair Trade Update In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 7% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel, Chart 11). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel, Chart 11). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel, Chart 11). Chart 11Still In Early Innings In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Importantly, the new/existing home sales–to-inventory ratio is an excellent leading indicator of relative share prices and is currently emitting an unambiguously bullish signal for homebuilders at the expense of HIR (Chart 12). Chart 12Supply/Demand Backdrop Says Stick With This Pair Trade Chart 13Relative Sales ##br##Expectations… Examining the relative demand backdrop reveals that homebuilders will continue to outshine HIR. Current readings in the NAHB home sales survey versus the remodeling survey and future expectations both point to more gains in the relative share price ratio (Chart 13). The felling in lumber prices also represents a benefit to homebuilders to the detriment of HIR. Lumber is a key building input cost in new home construction so any price liquidation is a boon for homebuilding margins. In contrast, HIR makes a set margin on lumber sales, therefore deflating lumber prices cut HIR profits (Chart 14). Chart 14…Felling Lumber Prices And … Chart 15…Bombed Out Valuations Signal More Relative Share Price Gains Finally, on the relative valuation and technical fronts, there is anything but froth. In fact, the relative price to book ratio is perched near an all-time low and relative momentum has only recently troughed and has yet to reach the neutral zone (Chart 15). In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs: … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2 Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3 Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4 Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5 BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6 Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7 Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8 Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights U.S.: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for rate hikes. Feature Global bond yields remain stuck in a range, seeking a new directional narrative. The downside is limited by green shoots of improving global growth (mostly from China stimulus), some commodity price reflation through higher oil prices and robust returns in most risk asset markets (i.e. an easing of financial conditions). At the same time, the upside for yields is capped by dovish forward guidance from data-dependent central banks who see below-trend economic growth and below-target inflation in the rearview mirror. Chart of the WeekForward MIS-guidance We expect these opposing forces to be resolved through faster global growth and higher realized inflation over the next 6-12 months. Major central banks will not need to turn even more dovish and begin a monetary policy easing cycle to boost growth, despite current market pricing suggesting otherwise. Global bond yields will grind upward, first through higher inflation expectations and, later, from a shift away from discounting rate cuts and, in some countries, pricing in rate hikes. The pressure for higher yields will be strongest in the U.S., where the Treasury market now discounts that the current 2.5% fed funds rate will be the cyclical peak, below the median FOMC projection, even as inflation expectations have been moving higher (Chart of the Week). We continue to recommend pro-growth, pro-risk allocations in global fixed income markets: below-benchmark overall duration exposure, favoring global corporates over government bonds, focusing government bond exposure to countries where policymakers will be relatively less hawkish (Japan, U.K., Australia, Canada, New Zealand), and positioning for faster inflation expectations and bearish steepening of yield curves (most notably in the U.S. and core Europe). May FOMC Meeting: Sorry, Mr. President The Fed kept rates unchanged at last week’s FOMC meeting, dashing market hopes of a potential shift in language toward a future rate cut. The official statement acknowledged that U.S. inflation was running below the 2% target, but Fed Chair Jerome Powell later described that inflation shortfall as “transitory” and expected to reverse. Treasury yields got whipsawed by the mixed messaging, with the 2-year yield falling -6bps after the statement but then climbing +11bps during Powell’s press conference. Powell standing his ground so firmly was a sharp rebuke to U.S. money markets, which remain priced for rate cuts over the next year. It was also a strong sign of the Fed maintaining its political independence in the face of U.S. President Trump calling for aggressive rate cuts. From a growth perspective, the Fed is right to not panic. The employment backdrop remains solid, with the U.S. unemployment rate hitting a 50-year low in April of 3.6%. While cyclical growth indicators like the ISM Manufacturing index have trended lower, the headline index remains above the expansionary 50 level (Chart 2). The rally in U.S. equity and credit markets seen so far in 2019 has eased financial conditions, signaling an imminent rebound in the U.S. leading economic indicator (second panel). Furthermore, core measures of retail sales and capital goods orders have begun to reaccelerate after the Q1 slump impacted by the U.S. government shutdown. From a growth perspective, the Fed is right to not panic. On the inflation side, the story is more nuanced. Higher oil prices will boost headline inflation measures over the next six months. At the same time, the lagged impact of the surprising pickup in U.S. productivity growth (+2.4% year-over-year in Q1) will help dampen core inflation rates (Chart 3) via lower unit labor costs (flat year-over-year in Q1). Further complicating the issue for the Fed is the impact of lower inflation in the components that Fed Chair Powell deemed “transitory”, such as airfares, apparel and, most interestingly, the cost of financial services. Chart 2A Blossoming U.S. ##br##Rebound Chart 3Blame Equities For The Cooling Of ##br##U.S. Core Inflation The broad Financial Services and Inflation grouping, which includes market-related costs such as wealth management fees, now represents 9% of the overall U.S. core PCE deflator. The inflation rate of the Financial Services index is highly correlated to the performance of U.S. equity markets (Chart 4). This makes sense, as the costs of professional portfolio management are often tied to the size of assets under management. At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. Chart 4Faster Productivity Means The Fed Can Be Patient In 2018, prior to the year-end correction in U.S. equity markets, the contribution to core PCE inflation from the Financial Services category was a steady 0.5-0.6 percentage points. After the market rout, that contribution has fallen to 0.2 percentage points, accounting for nearly all of the 40bp decline in core PCE inflation since U.S. equities peaked last September. With equity markets having now regained all the late-2018 losses, Financial Services inflation should boost core PCE inflation by at least 20-30bps by year-end – and perhaps more if stocks continue to appreciate, per the BCA House View. With our Fed Monitor now sitting just above the zero line, indicating no pressure on the Fed to hike rates, the -30bps of rate cuts now discounted over the next year is too aggressive (Chart 5). At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. The Fed will remain cautious on returning to a more hawkish stance until actual U.S. inflation turns higher, which will take some time given the competing forces of falling unit labor costs and fading “transitory” disinflationary effects. Chart 5Stay Underweight USTs & Below-Benchmark UST Duration We think the 2017 experience will be useful to think about in the coming months. Then, the Fed paused its rate hiking cycle for a few months, primarily due to softer inflation readings related to unusual forces temporarily dampening core inflation (most notably, a one-time collapse in wireless phone prices related to a change in how those costs were measured). Once those “transitory” forces faded out of the data, the Fed resumed lifting the funds rate. It will likely take longer in 2019 before the Fed would feel confident enough to begin raising rates again, especially with the funds rate now much closer to neutral than two years ago. Nonetheless, we expect a similar story of rebounding inflation driving Treasury yields higher to unfold over the latter half of this year. A moderate below-benchmark U.S. duration stance, favoring shorter maturities, combined with a long position in inflation-protected TIPS over nominal Treasuries, remains appropriate. Bottom Line: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada Update: Stay Neutral Back in March, we upgraded our recommended Canadian government bond exposure to neutral after spending a long time at underweight.1 The rationale for our move was that the stunning loss of momentum in the Canadian economy at the end of 2018 would force the Bank of Canada (BoC) to not only stop raising rates, but stay on hold for longer than expected. After our upgrade, we noted that we would consider additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey (BoS) and the updated economic projections at the April 24 monetary policy meeting. None of those events makes us want to move away from the current neutral recommendation. The problem for the BoC is that its policy rate of 1.75% remains well below its own estimated neutral range, which is now 2.25%-3.25% (Chart 6). A similar message comes when looking at the neutral real rate (“r-star”) estimate for Canada produced by the New York Fed, with an r-star of 1.5% versus a current real policy rate around 0%.2 This suggests that Canadian monetary policy remains accommodative and that the BoC should be looking for opportunities to continue moving interest rates toward “neutral” when the economy is accelerating. Yet our own BoC Monitor suggests that an unchanged policy stance is currently appropriate, while -11bps of rate cuts are now discounted in the Canadian Overnight Index Swap (OIS) curve. In other words, the BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. The BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. In the press conference following the April 24 BoC policy meeting, BoC Governor Steve Poloz noted that any reference to the need for interest rates to return to the BoC’s neutral range was deliberately omitted from the official policy statement. This is a clear signal that the central bank has shifted its focus from “normalizing” rates to preventing a deeper downturn in Canadian growth. The latest BoS showed that business confidence, expected sales and future investment intentions all fell sharply in the first quarter of 2019 (Chart 7). There was a huge drop in the number of firms reporting capacity pressures and labor shortages, with more firms now expecting their prices to fall than rise over the next year. The main headwinds to the diminished outlook for future sales were related to “a more uncertain outlook in the Western Canadian energy sector, continued weakness in housing-related activity in some regions, and tangible impacts from global trade tensions”.3 Chart 6A Long Way From BoC ##br##Rate Cuts Chart 7Negative Messages From The BoC Business Outlook Survey The BoC places a lot of weight on the BoS in determining its economic forecasts, and in setting monetary policy. Thus, it is no surprise that in the official statement following the April 24 monetary policy meeting, the BoC Governing Council noted that they were “monitoring developments in household spending, oil markets and global trade policy to gauge the extent to which the factors weighing on growth and the inflation outlook were dissipating”.4 Those were the same three concerns of businesses highlighted in the BoS, assuming that “weakness in the Canadian housing market” is related to “developments in household spending” – a logical link given the high level of Canadian household and mortgage debt. Looking at those three factors, there is nothing suggesting that the BoC needs to adjust policy anytime soon (Chart 8). Oil prices are rising, but household spending remains weak and global trade uncertainties have not completely diminished and Canadian export growth has stagnated. Given the mixed picture from the economic data, the BoC will likely remain on hold until there is a clear signal from the data. From a bond investment strategy perspective, staying at neutral also makes sense. A move to overweight Canadian bonds would require an even deeper economic downturn into recessionary territory that would push Canadian unemployment higher (Chart 9). Downgrading back to underweight, however, would require signs of a sustainable rebound in Canadian domestic demand and stronger global growth that would boost Canadian exports – an outcome that would not be visible in the data until at least the third quarter of 2019. Chart 8Watch What The BoC ##br##Is Watching Chart 9A Neutral Weight On Canada Is Still Justified One final point on staying neutral on Canada comes from looking at cross-country spread levels between government bonds in Canada and other major developed economies. The spread levels look historically wide versus sovereign debt from Germany, the U.K., and Australia; wide versus recent history in Japan; but very narrow versus the U.S. (Chart 9). Those spreads are shown without hedging out the currency risk of going long Canadian bonds – and, by association, the Canadian dollar. Once the currency risk is hedged out of those cross-country spreads using 3-month currency forwards, the spread differentials are all far less interesting both in absolute terms and relative to history (Chart 10 & 11). Chart 10Big Differences In Canadian Bond Spreads Vs Other Major DM... Chart 11… But Those Spreads Disappear Once The C$ Exposure Is Hedged So even on an individual country basis, there is no compelling case to be anything but neutral Canadian government bonds versus global currency-hedged benchmarks – which is how we present all our fixed income recommendations in Global Fixed Income Strategy. Bottom Line: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden Trade Update – Time To Retreat & Regroup Exactly one year ago (May 8, 2018), we initiated trades in our Tactical Overlay portfolio to position for tighter monetary policy, and higher bond yields, in Sweden.5 Specifically, we have been recommending shorting 2-year Swedish government bonds versus German equivalents (hedging the currency exposure back into krona), while also selling 2-year Swedish bonds and buying 10-year Swedish debt in a yield curve flattening trade. The positions were chosen to benefit from an expected bearish repricing of the short-end of the Swedish curve. At this time last year, the positive upward momentum of Swedish growth and inflation had reached a point where the Riksbank was clearly – and credibly – signaling that the long process of normalizing its highly accommodative crisis-era monetary policies would begin. That meant lifting policy rates away from negative territory, as well as shutting down the bond-buying quantitative easing (QE) program. One year later, the economic backdrop has done a 180-degree turn against our original thesis (Chart 12): Swedish growth has slowed, with both the manufacturing PMI and leading economic indicator at the lowest levels since 2013. Unemployment has increased and nominal wage growth has rolled over. Headline CPIF inflation has fallen back below the Riksbank 2% target, while core CPIF inflation remains stuck near 1.5%. The Riksbank changed its forward guidance at last month’s monetary policy meeting, signaling that the benchmark interest rate will remain at -0.25% for “somewhat longer” than was indicated as recently as February (when a rate hike around the end of 2019 or in early 2020 was signaled). The Riksbank also pledged to maintain the size of its QE bond purchases from July 2019 to December 2020, a dovish surprise. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. The minutes from last month’s policy meeting revealed that the forward guidance was adjusted simply because headline inflation had temporarily dipped back below the 2% Riksbank target. The implication is that a return to 2% inflation would prompt the Riksbank to hike. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. A useful rule for investment risk management is: when the underlying rationale for a position is clearly not unfolding as expected, the best thing to do is simply close that position and look for new opportunities better aligned to the current reality. Chart 12No More Pressure On Riksbank ##br##To Hike Chart 13Time To Exit Our Recommended "Hawkish" Trades In Sweden With that in mind, we are choosing to close our tactical trades in Sweden (Chart 13). The 2-year Sweden-Germany spread trade generated a loss of -52bps (including the return from hedging the euro exposure in Germany back into Swedish krona). We were more fortunate with the curve flattening trade, which generated a return of +61bps as the Swedish curve bullishly flattened through falling 10-year yields rather than bearishly flattening through rising 2-year yields (our original expectation). Thus, we are closing out our Sweden trades at a small net gain of +9bps. We will do a deeper analysis on Sweden in an upcoming Global Fixed Income Strategy report to search for new potential trade ideas. Bottom Line: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for a faster path of rate hikes. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “March Calmness”, dated March 19, 2019, available at gfis.bcaresearch.com. 2 The NY Fed’s estimates for non-U.S. r-star rates for the euro area, Canada, and the U.K. can be found on the NY Fed website. https://www.newyorkfed.org/research/policy/rstar 3https://www.bankofcanada.ca/2019/04/business-outlook-survey-spring-2019/ 4https://www.bankofcanada.ca/2019/04/fad-press-release-2019-04-24/ 5 Please see BCA Global Fixed Income Strategy Special Report, “Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore”, dated May 8, 2018, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
The Fed that has adopted an abruptly dovish stance and a recently inverted 10-year/fed funds rate yield curve indicates the market’s expectation that the next Fed move will be a cut, corroborated by elevated probabilities of a cut by December. This has driven a marked increase in client requests on positioning if rates are falling. Accordingly, we have updated our research to answer the question: what sectors perform best when the Fed eases? The results of our analysis of the seven Fed loosening cycles since 1965 are presented in the table below. The sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs. The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle. While we are not forecasting a cut and BCA’s view remains one of no recession for the coming 12 months, the production of this report may well be early. Nevertheless, its use as a sector positioning/return road map is evergreen; please see Monday’s Special Report for more details.
Highlights Chart 1Is Low Inflation Transitory? Persistent /pə’sıst(ə)nt/ adj. If inflation runs persistently above or below 2 percent, then the Fed would be forced to adjust its policy stance to nudge it back towards target. Transitory /’trænsıtərı/ adj. If inflation’s deviation from target is only transitory, it means that it will return to target even if the Fed maintains its current policy stance. Symmetrical /sı‘metrık(ə)l/ adj. The Fed’s inflation target is symmetrical because the FOMC is as concerned with undershoots as it is with overshoots. More recently, some members are urging the Fed to demonstrate the target’s symmetry by explicitly pursuing an overshoot. Last week, Chair Powell described recent low inflation readings as transitory (Chart 1). In other words, the Fed believes that interest rates are already low enough to send inflation higher over time. Equally, with downbeat inflation expectations signaling doubts about the symmetry of the Fed’s target (bottom panel), the committee is in no rush to hike. The result is status quo monetary policy for the time being. With the market priced for 25 basis points of rate cuts over the next 12 months, investors should keep portfolio duration low. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 95 basis points in April, bringing year-to-date excess returns up to +365 bps. The corporate bond sector’s strong outperformance has resulted in spread tightening across the credit spectrum. In fact, average index spreads for the Aaa, Aa and A credit tiers are now at or below our fair value targets.1 Only the Baa credit tier, which accounts for about 50% of index market cap, remains attractively valued, with an average spread 11 bps above target (Chart 2). We recommend that investors focus their investment grade credit exposure on Baa-rated bonds. The combination of above-trend economic growth and accommodative Fed policy creates a favorable environment for credit risk. Spreads should continue to tighten in the near-term. However, we will turn more cautious once Baa spreads reach our target. Gross corporate leverage ticked higher in Q4, breaking a year-long downtrend (panel 4). Meantime, while C&I lending standards eased slightly in Q1 after having tightened in Q4 (bottom panel), C&I loan demand contracted for the third consecutive quarter. Weaker loan demand in the Fed’s Senior Loan Officer Survey often precedes tighter lending standards, and tighter lending standards usually coincide with wider corporate bond spreads. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 137 basis points in April, bringing year-to-date excess returns up to +710 bps. Junk spreads for all credit tiers remain above our spread targets (Chart 3).2 At present: The Ba-rated option-adjusted spread is 214 bps, 35 bps above target. The B-rated spread is 356 bps, 79 bps above target. The Caa-rated spread is 709 bps, 145 bps above target. An alternative valuation measure, the excess spread available in the junk index after accounting for expected default losses, is currently 267 bps, slightly above average historical levels (panel 4). However, this measure uses the Moody’s baseline default rate forecast of 1.7% for the next 12 months. For that forecast to be realized, it would require a substantial decline from the current default rate of 2.4%. In a previous Special Report, we flagged some reasons why the Moody’s forecast might be too optimistic.3 Among them is the increase in job cut announcements, which remains a concern despite last month’s drop (bottom panel). If we assume that the default rate holds at 2.4% for the next 12 months, the default-adjusted junk spread would fall to 237 bps. Still reasonably attractive by historical standards, and consistent with positive excess returns. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in April, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 5 bps widening in the option-adjusted spread (OAS) was partially offset by a 4 bps drop in the compensation for prepayment risk (option cost). At 42 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains below the pre-crisis mean (Chart 4). In fact, we would assign high odds to MBS outperformance during the next few months. Not only is the OAS attractive, but mortgage refinancings – which have recently caused the nominal MBS spread to widen – have probably peaked (panel 2). Following its sharp decline earlier in the year, the 30-year mortgage rate has now leveled-off. Another downleg is unlikely, given the recent improvements in housing data. New home sales and mortgage purchase applications have both surged in recent months, while homebuilder optimism remains close to one standard deviation above its long-run mean.4 Moreover, even at current mortgage rates we calculate that only about 17% of the conventional 30-year MBS index is refinanceable. All in all, given that corporate credit offers higher expected returns, we continue to recommend only a neutral allocation to MBS. However, MBS spreads are very likely to tighten during the next few months. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in April, bringing year-to-date excess returns up to +152 bps. Sovereign debt outperformed duration-equivalent Treasuries by 83 bps on the month, bringing year-to-date excess returns up to +420 bps. Local Authorities outperformed the Treasury benchmark by 67 bps and Foreign Agencies outperformed by 40 bps, bringing year-to-date excess returns up to +208 bps and +192 bps, respectively. Domestic Agencies outperformed by 10 bps in April, bringing year-to-date excess returns up to +29 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +23 bps. The Fed’s on-hold policy stance and signs of improvement in leading global growth indicators could set the U.S. dollar up for a period of weakness. All else equal, a softer dollar makes USD-denominated sovereign debt easier to service, benefiting spreads. However, a period of dollar weakness driven by improving global growth would also benefit U.S. corporate bonds, and valuation is heavily tilted in favor of U.S. corporate debt relative to sovereigns (Chart 5). Given that the last period of significant sovereign outperformance versus corporates was preceded by much more attractive valuation (panels 2 & 3), we maintain an underweight allocation to sovereign debt for the time being. We make an exception for Mexican sovereign debt, where spreads are attractive compared to similarly rated U.S. corporates (bottom panel). Our Emerging Markets Strategy service also thinks that the market is taking too dim a view of Mexican government finances.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in April, and currently sits at 78% (Chart 6). This is more than one standard deviation below its post-crisis mean and slightly below the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) outperformed short-dated munis (2-year and 5-year) dramatically last month, but yield ratios at the long end remain well above those at the short end of the curve (panel 2). In other words, the best value in the municipal bond space continues to be found at the long-end of the Aaa muni curve. We showed in a recent report that lower-rated and shorter-maturity munis are much less attractive.6 First quarter GDP data revealed that state & local government tax revenues snapped back sharply in Q1, following a contraction in 2018 Q4. Meanwhile, current expenditures actually ticked down. Incorporating an assumption for Q1 corporate tax revenues, we forecast that state & local government interest coverage jumped to 16% in Q1 from 4% in 2018 Q4.7 This is consistent with municipal ratings upgrades continuing to outpace downgrades for the time being (bottom panel). Treasury Curve: Adopt A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in April. The 2/10 Treasury slope steepened 10 bps on the month and currently sits at 21 bps (Chart 7). The 5/30 slope steepened 7 bps on the month and currently sits at 60 bps. In recent reports we have urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.8 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. With recession likely to be avoided this year, the market will eventually price rate hikes back into the curve. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 8 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 5 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, almost all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 81 basis points in April, bringing year-to-date excess returns up to +157 bps. The 10-year TIPS breakeven inflation rate rose 13 bps on the month and currently sits at 1.91% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.02%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. As we noted in a recent report, the Fed has clearly pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.9 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Year-over-year core PCE inflation dipped to 1.55% in March. However, as Fed Chair Powell went out of his way to mention in last week’s press conference, core PCE was dragged down by one-off adjustments in the ‘Clothing & Footwear’ and ‘Financial Services’ components. In fact, 12-month trimmed mean PCE inflation actually moved up in March. It now sits at 1.96%, just below the Fed’s target (bottom panel). The combination of a dovish Fed and above-trend economic growth should push TIPS breakevens higher over time. Maintain an overweight allocation to TIPS versus nominal Treasuries. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in April, bringing year-to-date excess returns up to +49 bps. The index option-adjusted spread for Aaa-rated ABS narrowed one basis point on the month and, at 32 bps, it remains close to its all-time low (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 40 basis points in April, bringing year-to-date excess returns up to +187 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level but somewhat higher than levels seen last year (Chart 10). In a recent report, we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.10 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in April, bringing year-to-date excess returns up to +95 bps. The index option-adjusted spread tightened 2 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 25 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of April 30, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of April 30, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A High Bar For Rate Cuts”, dated April 30, 2019, available at usbs.bcaresearch.com 5 Please see Emerging Markets Strategy Special Report, “Mexico: The Best Value In EM Fixed Income”, dated April 23, 2019, available at ems.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Corporate tax revenue is not released until the second GDP estimate. We assume that the 2019 Q1 value equals the 2018 Q4 value. 8 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation