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Highlights Portfolio Strategy Stick with a neutral weighting in the tech sector as rising interest rates, higher inflation and a firming greenback offset improving industry operating metrics on the back of the virtuous capex upcycle. Chip and chip equipment stocks will remain under pressure as global semi sales are under attack and leading indicators of semi demand suggest that more pain lies ahead at a time when chip selling prices are steeply decelerating. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities regained their footing last week and remain perched near all-time highs. Investors are largely ignoring the trade-related uncertainty and are instead focusing on the upbeat economic backdrop. Both soft and hard data continue to send an unambiguously healthy signal for the U.S. economy, a potent tonic for corporate profitability. Chart 1EPS Will Do All The Heavy Lifting While a lot of parallels have been drawn between today and the late-1990s, our sense is that the current financial market and economic outlooks resemble more the mid-2000s. Chart 1 shows that, between 2004 and the stock market peak in late-October 2007, forward profit growth estimates peaked at over 20%/annum and the forward multiple drifted steadily lower. Nevertheless, stocks remained well bid and rose alongside forward EPS (top and third panels, Chart 1). In other words, despite decelerating forward profit growth estimates and a contracting forward multiple, expanding forward EPS did the heavy lifting, explaining all of the advance in the SPX. The similarities to today are eerie: while profit growth peaked in Q1/2018, 10% EPS growth is elevated for the tenth year of an expansion, and the forward multiple is coming in (Chart 1). On the policy front, the Bush tax cuts hit in the mid-2000s with the elimination of the double taxation of dividends and a drop in personal income tax rates, along with a one-time cash repatriation of corporate profits stashed abroad. With regard to the economic backdrop, capex was roaring and nominal GDP was firing on all cylinders as a housing bubble was getting inflated. The GDP deflator also hit a high mark. The ISM manufacturing survey eclipsed 61 in 2004 and non-farm payrolls were expanding smartly (Chart 2). But despite all that apparent overheating especially in the housing market, the real fed funds rate was near zero in 2004 (top panel, Chart 3). Finally, a number of financial market metrics were also similar to today. Oil prices were on their way to triple digits, high yield spreads were below 400bps and the VIX probed, at the time, all-time lows (Chart 3). However, one key difference between the mid-2000s and today is the strengthening U.S. dollar. The firming greenback remains a key risk to our positive equity market view (bottom panel, Chart 3), as it will eventually infiltrate EPS. Netting it all out, if history at least rhymes, an earnings-led advance in the SPX is the most likely outcome. Our sanguine cyclical (9-12 month) equity market view remains predicated on a 10%/annum increase in EPS and a sideways-to-lower move in the forward multiple. Meanwhile, wage inflation is slowly starting to rear its ugly head. In fact, we are surprised by the fits and starts in average hourly earnings growth. At this stage of the cycle, wage growth should start galloping higher as executives aggressively bid up the price of labor in order to fill job openings and bring expansion plans to fruition. A simple wage growth indicator comprising resource utilization and the unemployment gap suggests that wage inflation will really kick into higher gear in the coming 12 months (shown as a Z-score, Chart 4). Chart 2Eerie... Chart 3...Parallels With 2004 Chart 4Mind The Return Of Inflation Two weeks ago we highlighted that the S&P 500's profit margins are benefiting from lower corporate taxes and muted wage growth, a goldilocks backdrop. Despite evidence of a pending inflationary impulse, as long as businesses are successful in passing rising input costs down the supply chain and onto the consumer, then margins and EPS will continue to expand. Nevertheless, deconstructing the SPX's all-time high profit margins is in order. Chart 5 & Chart 6 show the 11 GICS1 sector profit margin time series using Standard & Poor's data, and Chart 7 is a snapshot of Q2/2018 profit margins for the 11 sectors and the broad market. Chart 5Sectorial Profit ... Chart 6...Margin Breakdown Chart 7Tech Is A Clear Outlier Five sectors (tech, industrials, materials, consumer discretionary and utilities) are enjoying record-high profit margins, and four (financials, consumer staples, telecom services and real estate) are on the verge of joining that club. This leaves two sectors with declining margin profiles: health care and energy. While most sectors are +/- five percentage points away from the S&P 500, the tech sector sports profit margins at twice the level of the SPX or eleven percentage points higher and is the clear outlier (Chart 7). The implication is that the broad market's EPS fortunes are closely tied to the high-flying tech sector that commands a 26% market cap weight. Thus, this week we are compelled to highlight the deep cyclical tech sector, and two of its hyper-sensitive and foreign exposed subcomponents. Tech On Steroids In late-August we published a chart on tech margins (which we are reprinting today) showing the upward force they have exerted on the broad equity market for the better part of the past decade (top panel, Chart 8). Naturally, stratospheric profits must underpin these parabolic margins. The middle panel of Chart 8 highlights that since 2006 tech EPS have almost quadrupled, pulling SPX profits higher. As a reminder, the S&P tech sector commands a 24% profit weight in the S&P 500, the highest since the history of this data series and almost double the weight during the previous cycle's peak (bottom panel, Chart 8). The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. Chart 8Secular Tech EPS Growth Has Boosted Margins Chart 9EPS Growth Model Flashing Green On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (Chart 9). The virtuous capex upcycle - BCA's key theme for the year - remains the key driver behind our EPS model. Chart 10 shows that the tech sector continues to make inroads in the overall capex pie, according to financial statement-reported data, and has now doubled its share since the GFC trough to roughly 12%. National accounts corroborate this data and underscore that pent up demand is getting unleashed, following a near 15-year hibernation period (bottom panel, Chart 10). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity1 - is reaccelerating. Tech new orders-to-inventories are also picking up steam and suggest that sell side analysts have set the relative EPS bar too low (Chart 11). Finally, the latest PCE report revealed that consumer outlays on tech goods are also gaining momentum, even relative to overall consumer spending. While this upbeat backdrop would point to an above benchmark tech allocation, three risks keep us at bay. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind, especially for 2019 when the delayed negative FX translation effects will most likely emerge (third panel, Chart 12). Chart 10Capex On The Upswing... Chart 11...Underpinning Tech Operating Metrics... Chart 12...But Three Risks Keep Us At Bay Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Tech business models are built to withstand deflation and thrive in a disinflationary environment. Thus, when inflation re-emerges, tech stocks suffer (CPI and 10-year UST yield shown inverted, top two panels, Chart 12). Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM in general and tech-laden Korean and Taiwanese economic data in particular would retrench further (bottom panel, Chart 12). Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. As a reminder we continue to express our bullishness via two high-conviction overweight defensive tech sub-sectors, S&P software and S&P tech hardware, storage & peripherals (THSP), and our bearishness via avoiding their early cyclical peers, S&P semis and S&P semi equipment. Avoid Chip Stocks At All Costs While we are neutral the broad tech sector and prefer secular growth defensive tech sub-sectors, we continue to recommend shying away from chip and chip equipment stocks. Chart 13 shows the extreme sensitivity to changes in final demand of chip related stocks versus their defensive tech peers. In more detail, software and THSP indexes are in a secular advance with regard to EPS outperformance, whereas semis and semi equipment profits are hyper-cyclical with mean-reverting relative profit profiles. Granted, the commoditization of semiconductors explains this close correlation with the business cycle. But, as we highlighted last November when we put the semi equipment index on the high-conviction underweight list, extrapolating EPS growth euphoria far into the future was fraught with danger.2 In fact, late-November 2017 marked the peak in semi equipment performance versus the overall IT sector, confirming the early cyclical nature of chip stocks (Chart 14). Chart 13Bifurcated EPS Chart 14Good Times... Three factors have weighed heavily on this industry's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (top panel, Chart 15). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (Chart 16). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel, Chart 15). Chart 15...Do Not Last Forever Chart 16Semi-Heavy Taiwan Emits A Grim Signal The outlook for their brethren, semi producers, is equally downtrodden. Global semi sales have crested and leading indicators of future semi revenue growth are sending a warning signal. Chinese imports of electronics have come to an abrupt halt, and the U.S. dollar's appreciation is also waving a red flag (second & bottom panels, Chart 17). BCA's calculated global leading economic indicator excluding the U.S. and BCA's calculated global ZEW Indicator of Economic Sentiment excluding the U.S. both herald a steep deceleration in global semi sales (Chart 17). On the pricing power front, using Asian DRAM prices as an industry pricing power gauge, DRAM momentum is on a trajectory to contract some time in Q1/2019. The implication is that semi earnings will surprise to the downside. Still expanding global chip inventories are not providing an offset and also confirm that semi EPS optimism is unwarranted (middle & bottom panels, Chart 18). Finally, another source of demand for chip stocks has reversed, as industry M&A activity has plummeted toward decade lows. Not only is this negative for pricing power, but inflated premia are also now working in reverse especially given this year's QCOM/NXPI and AVGO/QCOM flops (top panel, Chart 18). Our Chip Stock Timing Model (CSTM) does an excellent job encapsulating all these moving parts and is currently in the sell zone (bottom panel, Chart 19). Chart 17Global Semi Sales Trouble... Chart 18...Abound Chart 19Chip Stock Timing Model Says Sell Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights The USD remains supported by fundamentals, especially now that its late-2016 excesses have been purged. Solid U.S. growth contrasts with weaker growth in the rest of the world, which will incentivize further inflows into the U.S. dollar. Despite this positive cyclical view, the tactical outlook remains risky for dollar bulls. In the immediate term, the euro will benefit from easing Italian tensions and as well as from the dollar's correction, but its six-month outlook remains poor. The AUD could also rebound right now, but any such rally should be used to build further short positions. Feature After a furious rally from February to August, the dollar has been weakening since the middle of last month. Since July, we have been worried that the dollar could stage a bit of a correction,1 but we remained committed to the view that ultimately the greenback would rise further in 2018. It is now time to review whether this thesis still holds. BCA believes that the USD's correction could run through the fall, but that the final quarter of 2018 should still prove a rewarding period for dollar bulls. Ultimately, policy divergences will remain a crucial support for the dollar, especially as EM weakness continues to affect the distribution of growth across the globe. USD: Not Yet Extended The dollar ultimately follows the path implied by its fundamental drivers - whether they are interest rate spreads, growth and inflation differentials, relative equity prices, or even relative money-supply growth. However, the path taken by the USD around its drivers is rather wide, and the dollar regularly overshoots and undershoots the equilibrium implied by the aggregation of all these fundamentals (Chart I-1). Academics call this the "band of agnosticism." Chart I-1The Dollar To Follow Fundamentals Higher This cycle was no exception. BCA's Fundamentals Index for the dollar hooked up in 2011, a move associated with a turning point in the greenback itself. However, the dollar remained in undershoot territory for many years. Then suddenly, in 2014, the coiled spring was released and the dollar surged higher, moving above its "band of agnosticism" in 2015 - a moved exacerbated by the sudden rally that followed the election of Donald Trump in November 2016. Once the dollar had become over-loved, over-owned and expensive, it also became vulnerable. The pick-up in global growth that was so evident in 2017 caused a serious correction in this vulnerable currency. However, the selloff had a positive impact: U.S. growth, interest rates, equities and so on continued to move favorably, and the dollar is now positioned to rebound anew, having purged its most egregious excesses. The global economic backdrop is also positive for the dollar. For one, the theme of monetary divergences is still at play. Boosted by a healthy banking sector, healthy household balance sheets and an untimely fiscal stimulus of 1.7% of GDP, U.S. growth has hit 2.8%, well above potential. Moreover, growth has been above potential for eight years, and now U.S. capacity utilization is at its tightest level since the late 1980s. Historically, so large an absence of slack has been linked to higher U.S. interest rates (Chart I-2). Yet interest rate markets are pricing in roughly four increases over the next 24 months, even as Lael Brainard warned that the Federal Reserve could move beyond the hikes implied by its own forecast, the "dot plots." Chart I-2Tight Capacity Utilization Implies Higher U.S. Rates... The U.S. economy continues to fare well, as U.S. real interest rates remain 60 basis points below neutral rates and the yield curve has yet to invert. However, U.S. rates matter for the rest of the world as well. There, the picture is less pretty. EM dollar debt stands near record levels (Chart I-3). Hence, EM financial conditions have been hit by the combined assault of higher U.S. rates and an appreciating dollar. Nowhere is this clearer than when looking at the interplay between U.S. bond yields and the South African rand or AUD/JPY, a cross highly correlated to EM currencies. This cycle, rising U.S. bond yields have most often been associated with a rising ZAR or a rising AUD/JPY (Chart I-4). However, this time around, as was the case during the May 2013 Taper Tantrum, rising bond yields are linked to these pro-cyclical currency pairs falling. This suggests that rising yields are not reflecting global growth anymore, and are in fact restrictive for the rest of the world, even if they are not a problem for the U.S. Chart I-3... Which Will Hurt EM Economies Chart I-4Higher U.S. Rates Now Hurt Global Growth This inference is underpinned by the decline in BCA's U.S. Financial Liquidity Index, which heralds additional weakness in global growth and commodity prices (Chart I-5). Already we are seeing symptoms of the malaise. Japanese foreign machine tool orders are contracting, and BCA's Asian Leading Economic Indicator is in deep contraction (Chart I-6). Chart I-5Dollar Liquidity Is A Problem For Growth Chart I-6Signs That Global Growth Is Already Suffering A rising fed funds rate and falling ex-U.S. growth is likely to continue to support the dollar. The dollar loves nothing more than falling global growth. The U.S. economy has low exposure to global trade and to the global industrial sector, and therefore when global growth slows, the U.S. economy is relatively insulated from foreign shocks. This means that U.S. rates of return do not suffer as much as foreign ones. This is even truer in the rare instances when global growth slows while U.S. economic activity continues to power ahead, especially when artificially inflated by untimely fiscal stimulus. This is a characterization of the current environment. Hence, money will continue to flow into the U.S. economy on a two- to three-quarter horizon. In fact, portfolio flows into the U.S. remain well below the levels that prevailed during the previous decade (Chart I-7). The current account deficit is also smaller, hence, if net foreign portfolio flows can increase due to the attraction of higher U.S. rates of return, the U.S. balance of payments will move into a greater surplus, creating a strong underpinning for the dollar. This positive cyclical backdrop for the greenback is not without impediments. Most crucially are the short-term dynamics. Since July, we have been warning clients that a tactical correction in the dollar was likely. While EUR/USD has indeed rebounded, most other currencies have displayed rather tepid performances. This does not mean that the tactical risks to the dollar have abated. Quite the opposite, they are rising. As Chart I-8 illustrates, a large buildup in dollar longs has materialized, yet the G10 economic surprise index is making a trough. Moreover, the diffusion index of the BCA Global Leading Economic indicator is also stabilizing. Additionally, USD /CNY has failed to make new highs and the Turkish central bank just raised rates to 24% - which if Argentina is any guide is likely to provide only temporary relief for the TRY. This means that a period of risk-on sentiment in EM could emerge. Stretched dollar positioning, a temporary stabilization in global growth and EM inflows could precipitate a serious correction in the dollar. Chart I-7Dollar Favorable Flows Chart I-8Tactical Risks To The Dollar Bottom Line: The dollar is still supported by potent cyclical tailwinds. The U.S. economy is roaring and at full employment, yet global growth is suffering because global liquidity conditions are deteriorating. Higher rates of return in the U.S. will therefore attract additional capital, supporting the greenback in the process. Despite this positive cyclical backdrop, the short-term outlook is murkier. Speculators have aggressively bought the dollar, leaving them vulnerable to any positive surprises in global growth, even temporary ones. Fade The Euro Rebound The euro has benefited from the cool-off in Italian politics. The populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels, as Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit, while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. As a result, the spread between Italian BTPs and German bunds has fallen from 193 basis points at the beginning of the month to 150 basis points this week (Chart I-9). Since gyrations in Italian spreads reflect the evolution of the perceived probability that the euro area will fall apart, the fall in the spreads has implied a fall in the euro area-breakup risk premium. This has created a boon for the euro. Another support for the euro emerged yesterday. At his press conference, European Central Bank President Mario Draghi divulged that the ECB has curtailed its growth forecast for 2018 and 2019, but not its inflation forecast. In fact, Draghi went as far as mentioning that his confidence that euro area inflation would move back to target in the medium term has increased. There is no denying that the inflationary backdrop has improved as European wages and labor costs have indeed starting to recover (Chart I-10). However, the picture is not that straightforward. The lagged impact of the previous fall in euro area inflation relative to the U.S. is likely to continue to be felt in EUR/USD moving forward, as has been the case over the past 10 years (Chart I-11). Chart I-9The Euro Area Break Up Risk Premium Is Declining Chart I-10Rising Euro Area Labor Costs Chart I-11Relative Inflation Backdrop Is Still Euro Bearish This risk is compounded by developments in China. As we have often argued, the growth differential between the euro area and China can largely be explained by growth dynamics in China. As Chart I-12 illustrates, when Chinese monetary conditions tighten, or when China's marginal propensity to consume - as approximated by the gap between M1 and M2 - declines, this often leads to underperformance of European economic activity relative to the U.S. Chart I-12AChinese Economy Still Hurting Euro Area Vs U.S. (I) Chart I-12BChinese Economy Still Hurting Euro Area Vs U.S. (II) Today, Chinese monetary conditions have improved somewhat as the Chinese authorities try to combat the shock to the Chinese economy created by the growing trade war between the U.S. and China. However, Matt Gertken, BCA's Geopolitical Strategy service's expert on Chinese policy, believes that Chinese policymakers do not intent to actually cause economic growth to pick up. Indeed, they are committed to reform and deleveraging, and only want to limit downside to the Chinese economy.2 Thus, the large growth gap between the U.S. and the euro area is here to stay. As markets absorb news of Chinese stimulus, EUR/USD could rebound toward 1.19, but we are inclined to fade such a rebound. For one, the growth and inflation gap between the U.S. and the euro area remains euro bearish. Additionaly BCA's Central Bank Monitor for the Fed clearly points toward the need to tighten U.S. monetary policy, while our indicator for the ECB points to the need to maintain an extremely loose policy setting in Europe (Chart I-13). With the euro still trading above its intermediate-term fair value estimate (Chart I-14), beyond any short-term rally the euro still possesses ample downside in the fourth quarter. As such, we would use the current rebound in the euro as an opportunity to buy the dollar once again. Chart I-13The U.S. Needs More Tightening, Europe Does Not Chart I-14The Euro Possesses Downside Bottom Line: Falling risk premia in Italy, a pick-up in European wages and signs of stimulus in China are creating some support under the euro. However, European growth and inflation are set to continue to lag well behind the U.S. as China's stimulus is not designed to reverse its deleveraging campaign and boost growth, but instead to limit downside to growth created by the U.S.-China trade war. Hence, we will use the current rebound in the euro and correction in the USD to buy the greenback again in the coming weeks. What's Going On Down Under? In recent months, the Australian economy has managed to generate some impressive numbers on the employment front. However, until recently this was not enough to prompt investors to push the AUD higher. In fact, as recently as Monday, AUD/USD was trading at 0.71. Investors are skeptical about the Australian economy's underlying strength. The NAB Business Confidence for the Next Period has weakened sharply, while mortgage approvals and house prices have also sagged. This suggests that new orders, employment and consumption could follow lower (Chart I-15). This represents a big problem for the Aussie, as our central bank monitor for the Reserve Bank of Australia is already in "easing required" territory (Chart I-16). The RBA will therefore not be able to hike rates any time soon, despite the fact that U.S. interest rates are currently in an uptrend. As such, interest rate differentials between Australia and the U.S. will continue to deteriorate. Chart I-15Australia Is Set To Slowdown Chart I-16China And Australia Are Joined At The Hip Moreover, Australia has been hit directly by the decline in Chinese industrial activity. As Chart I-17 illustrates, Australian exports are a direct function of China's Li-Keqiang index. This has two implications. First, the current rebound in the Li-Keqiang index suggests that investors could bid up the AUD with great alacrity if the USD were to correct further, a thesis we espouse. However, since we do not anticipate the rebound in the Li-Keqiang indicator to have much longevity, nor do we anticipate the greenback's correction to morph into a bear market, this also means that we would use any rebound in the AUD to sell more of it. Beyond China, EM at large still constitutes a risk for AUD/USD. Arthur Budaghyan, our Chief EM strategist, argues that the period of weakness in EM assets has further to run. Our views on the U.S. dollar, on declining global liquidity and on Chinese policy corroborate this assessment. If EM economies slow further, the still-elevated expected long-term growth rate in EM earnings could decline further as well. Since growth expectations on EM EPS are indicative of expected interest rates and terms-of-trade for Australia, this also suggests that the AUD could suffer significant downside in the coming quarters (Chart I-18). Finally, the AUD remains a pricey currency. AUD/USD continues to trade significantly above its purchasing-power-parity fair value, and the real trade-weighted AUD remains above its long-term average (Chart I-19). As such, the AUD does not possess the required valuation cushion to make it a buy in this challenging context. Chart I-17RBA ##br##Cannot Hike Chart I-18EM Has Yet To Be Fully Re-Rated, ##br##And So Does The AUD Chart I-19No Valuation Cushion##br## In The AUD Bottom Line: The Australian economy has posted some solid employment numbers, but the trends in business confidence and the housing market augur poorly. Australian monetary policy will have to remain very loose. Moreover, since China's stimulus is likely to be limited, any rebound in the AUD on the back of a dollar correction should be faded, especially as the Aussie does not offer any valuation cushion. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Time To Pause And Breathe", dated July 6, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "China: How Stimulating is The Stimulus?", dated August 24, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Average hourly earnings growth outperformed expectations significantly, coming in at 2.9%. Moreover, nonfarm payrolls also surprised to the upside, coming in at 201 thousand, but this was mitigated by large downward revisions to the previous two months. Additionally initial jobless claims surprised positively, coming in at 203 thousand. However, core inflation underperformed expectations, coming in at 2.2%. Finally, DXY has been flat for the past couple of weeks. We continue to be bullish on the dollar on a cyclical basis, as inflationary pressures will continue to accumulate in the U.S., causing the fed to hike more than expected, particularly in 2019. Moreover, high U.S. borrowing cost will likely weigh on global growth, giving an additional boost to the dollar, as the U.S. has a lower beta than other DM economies to the global economic cycle. Report Links: The Dollar And Risk Assets Are Beholden To China’s Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the euro area has been negative: Both headline and core inflation surprised to the downside, coming in at 2% and 1% respectively. Moreover, industrial production yearly growth also surprised to the downside, coming in at -0.1%. Finally, retail sales yearly growth also underperformed expectations, coming in at 1.1%. EUR/USD has been flat the past two weeks. Yesterday, however the market rallied as the ECB confirmed that it expects to wind down its bond-buying program. Nevertheless, it also lowered growth forecast for this year and next. We continue to believe that the euro will have downside until the end of the year, as a policy and regulatory tightening in China will weigh on the global industrial cycle, to which Europe is highly levered. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: Tokyo ex fresh food inflation outperformed expectations, coming in at 0.9%. Moreover, overall household spending yearly growth also surprised positively, coming in at 0.1%. However, labor cash earnings yearly growth underperformed expectations substantially, coming in at 1.5%. Finally, Markit Services PMI surprised to the downside, coming in at 51.5. USD/JPY has been flat the past couple of weeks. Overall, we are bullish on the yen against the euro and the commodity currencies, as the tightening in monetary policy in the U.S. as well as in China should create a risk off environment where safe heavens like the yen benefits and cyclical currencies suffer. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been mixed: Average hourly earnings yearly growth excluding and including bonuses both came in above expectations, at 2.9% and 2.6% respectively. Moreover, Markit Services PMI also outperformed expectations, coming in at 54.3. However, industrial production surprised to the downside, coming in at 0.9%. Finally, nationwide housing prices yearly growth also surprised negatively, coming in at 2%. GBP/USD has rallied by roughly 0.5% the past couple of weeks. We believe that the pound could have some short term upside, as positioning continues to be significantly bearish. That being said, we are bearish on the pound on a cyclical basis, particularly against the yen. At this moment, the pound does not appear to have much of a geopolitical risk premium embedded in its price. Thus, any turbulence in the Brexit negotiations could result in significant downside for the GBP. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Gross domestic product yearly growth came in above expectations, at 3.4%. However, building permits month-on-month growth surprised to the downside, coming in at -5.2%. Finally, the RBA Commodity Index SDR yearly growth surprised positive, coming in at 6.7%. After a bout of pronounced weakness, AUD/USD has been flat for the past couple of weeks. We believe that the Australian dollar has further downside particularly against the yen and the dollar. Australia's economy is very sensitive to the Chinese industrial cycle, as iron ore is Australia's main commodity export. However, the overleveraged industrial complex is precisely the economic sector where Chinese policymakers want to rein in credit excesses. This will curb industrial activity in China, and hurt the economies of commodity supplies like Australia. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar Recent data in New Zealand has been mixed: Retail sales and retail sales ex autos yearly growth both outperformed expectations, coming in at 1.1% and 1.4% respectively. Moreover, the trade balance also surprised to the upside, coming in at -4.4 billion dollars/ However, the terms of trade Index underperformed expectations, coming in at 0.6%. NZD/USD has fallen by roughly 0.8% against the dollar for the past couple of weeks. We continue to be bearish on kiwi on a cyclical basis. The combination of high U.S. rates and deleveraging in China will weigh on carry currencies like the NZD. Furthermore, we also hold a bearish view on a structural basis, given that the new government has vowed to curb immigration and add an unemployment mandate to the RBNZ, both developments which are negative for the currency. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Both core and headline inflation outperformed expectations, coming in at 1.6% and 3% respectively. Moreover, manufacturing shipments month-on-month growth also outperformed expectations, coming in at 1.1%. However, retail sales month-on-month growth surprised to the downside, coming in at -0.2%. USD/CAD has been flat for the past couple of weeks. We are short this cross as a hedge to our dollar bullish view, as inflationary pressures in Canada remain strong. Moreover, the CAD will continue to outperform the AUD, as the divergence between Canada's and Australia's main export markets- China and the U.S. - will persist. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc Recent data in Switzerland has been mixed: Gross domestic product yearly growth outperformed expectations, coming in at 3.4%. The SVME PMI also surprised to the upside, coming in at 64.8. However, the KOF leading indicator surprised negatively, coming in at 100.3. Finally, real retail sales growth also underperformed expectations, coming in at -0.3%. EUR/CHF has risen by roughly 0.5% this past two weeks. We continue to be bearish on the franc on a long-term basis, as inflationary pressures in Switzerland are still too weak for the SNB to remove its accommodative monetary policy, or stop its currency intervention. That being said, the CHF could experience some short term upside if the sell-off in emerging markets continues. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone Recent data in Norway has been mixed: Both headline and core inflation outperform expectations, coming in at 3.4% and 1.9%. Moreover, the Labour Force survey also surprised to the upside, coming in at 3.9%. However, retail sales growth underperformed expectations, coming in at 0.7%. USD/NOK has fallen by nearly 2% over the last two weeks. We are bullish on the NOK against other commodity currencies like the AUD and the NZD. This is because oil will likely outperform within the commodity space. After all, Our commodity strategist have explained at length why political risk in Iraq and Venezuela could cause a shortage of supply in the oil markets, while Chinese deleveraging in the industrial sector will weigh on base metal demand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at -1.2%. However, consumer confidence outperformed expectations, coming in at 102.6. The krona has been the best performing currency during the past two weeks, with USD/SEK falling by roughly 2% over this period. At the moment we continue to be bullish USD/SEK, as the krona is the most sensitive currency to the dollar's strength. However, on a longer term basis, we believe that inflationary pressures in Sweden will ultimately force the Riskbank to hike more than the market expects, providing support for the SEK. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Oil markets and U.S. monetary policy are tightening coincidentally. This confluence of events in the past typically presages an equity correction and recession in the U.S. in the following 6 to 18 months (Chart of the Week). EM economies also could weaken as Fed policy collides with the oil-price spike we expect in the wake of a supply shock. In spite of continuing pressure from the Fed's policy-rate normalization policy, we continue to favor gold as a portfolio hedge (see below). Energy: Overweight. Russia's energy minister Alexander Novak expressed his determination to cooperate with OPEC to evolve the current production cut and emphasized his willingness to maintain a stable market, as reported by Platts on Tuesday.1 Base Metals: Neutral. Alcoa workers at Western Australian alumina and bauxite facilities voted to extend a strike initiated on August 8. Precious Metals: Neutral. The odds of sharply higher oil prices colliding with rising U.S. interest rates are increasing as the year winds down. Gold will outperform equities in this environment. Ags/Softs: Underweight. Brazilian farmers are lobbying Chinese consumers and Argentine suppliers to establish a futures contract tailored for delivery of soybeans from Latin America to China.2 Feature Oil markets continue to tighten, as the now fully discounted loss of ~ 2mm b/d of Iranian and Venezuelan exports is compounded by additional supply-side concerns in Iraq and Libya, and razor-thin OPEC spare capacity. Global demand remains robust. Against this backdrop, it is hardly surprising the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia are huddling with the U.S. Energy Secretary this week to discuss oil markets in separate meetings on opposite sides of the globe.3 The risk an oil-supply shock collides with tightening monetary conditions in the U.S. is rising, as the Fed continues its rates-normalization policy. This potent confluence of risks, which could push Brent prices above $120/bbl, raises the odds of a sharp correction in U.S. equities (Chart of the Week). It also could pull the recession we expect in 2020 into 2019. This is a risk assessment, not our baseline scenario. While the odds of an oil-price spike accompanied by higher interest rates are increasing, we are not changing our view of oil or gold markets: We expect Brent crude to average $70/bbl in 2H18 and $80/bbl in 2019. We also remain long gold as a portfolio hedge against higher inflation this year and next, and expect the Fed to stay the course on its rates-normalization policy.4 Chart of the WeekOil Price Spikes + Rising U.S. Interest Rates Typically Presage S&P 500 Sell-Off That said, gold will remain one of the best indicators of how markets assess the Fed's willingness to lean into its rates policy: If prices weaken further, it will signal markets are pricing in continued tightness in U.S. monetary policy. Any weakness resulting from this expectation will be an opportunity to get long (or longer) gold as a portfolio hedge, particularly if oil markets tighten as we expect. Energy Ministers Meet As Oil Markets Tighten KSA's minister, Khalid al-Falih, and U.S. Energy Secretary Rick Perry met in Washington this past Monday, and Perry is due to travel to Moscow for a scheduled visit today. The increasing likelihood of 2mm b/d of exports being lost to U.S. sanctions against Iran later this year, and the imminent collapse of Venezuela, provides the context for these meetings. Platts Analytics estimates as much as 1.4mm b/d of Iranian exports could be lost to the market by the time U.S. sanctions against that country kick in in November. In our base case, we expect a loss of 1mm b/d, which keeps the global market in a physical deficit next year (Chart 2). Total OPEC production in August is estimated by Platts at 32.9mm b/d, a 10-month high, with output in Iraq surging to 4.7mm b/d and to 940k b/d in Libya.5 That Iraqi and Libyan production surge is increasingly at risk, however. In addition to the fully discounted Iranian and Venezuelan risk, we expect American, Saudi and Russian ministers also will discuss the growing risk to Iraq's and Libya's production, and its implications for global supply.6 Civil unrest in these states raises the risk of additional unplanned outages over the near term just as output is recovering.7 Concerns over razor-thin OPEC spare capacity - equal to ~ 1.5% to 2.0% of global demand - and continued strong global consumption likely number among their concerns, as well. In our view, these factors strongly suggest the oil market is setting up for a supply shock that could lift prices above $120/bbl (Chart 3). Chart 2Physical Deficits Could Widen Chart 3High-Price Scenarios Becoming More Likely Fed Policy Could Collide With Oil Price Spike With the U.S. economy at or very near full capacity, unemployment below 4%, and inflation and inflation expectations ticking higher, we believe the Fed will remain focused on its rates-normalization policy. This increases the risk an oil-supply shock collides with tightening monetary conditions in the U.S. is rising. If the Fed looks through the oil-price spike we expect in the next 6 to 12 months - treating it as a transitory event - its rates-normalization policy will become problematic for the U.S. and global economies. Such a reading by the Fed would be a policy error, in our estimation. As shown in the Chart of the Week, an oil-supply shock accompanied by continued Fed tightening raises the risk of a sharp correction in U.S. equity markets, and perhaps could trigger a bear market. In addition, the recession we expect later in 2020 could be pulled into 2019. As shown in Table 1, 10 out of the 11 recessions in the U.S. since 1945 were preceded by spikes in oil prices. Not every rise in oil prices was accompanied by a recession. In other words, recessions in the U.S. are usually preceded by spikes in oil prices, but not all spikes in oil prices are followed by recessions. This is important, as it implies that forecasting a recession based solely on rises in oil prices can sometimes misfire. Table 1History Of Oil Supply Shocks On the other hand, an oil-price shock combined with a rate-tightening cycle presents a more reliable recession signal. In fact, since 1970, every time the Fed-funds rate rose by more than ~200bps and oil prices rose by more than 50%, the U.S. business cycle peaked in the following 6-18 months.8 EM Growth Threatened, As Well As the Fed proceeds with its policy-rate normalization, the broad trade-weighted USD (USD TWIB) will strengthen. A sharp increase in oil prices accompanied by continued strength in the USD TWIB will redound to the detriment of EM economies, reducing demand for commodities generally, as the local currency costs of all USD-denominated goods increases. The confluence of these factors - should they materialize - would reduce EM income growth - perhaps even cause a contraction - and would produce a medium-term deflationary impulse, along with a rush to U.S. treasuries and other safe-haven assets. This would lower U.S. interest rates, all else equal, forcing the Fed to put its rates-normalization policy on hold, and possibly reverse it.9 Favor Gold, If Oil Spikes And Rates Rise In sum, the U.S. economy is at or very near full capacity, which will keep the Fed focused on its rates-normalization process. This will likely cause the Fed to treat the oil-price spike we expect on the back of a supply-side shock over the next 6 - 12 months as transitory. The Fed won't view it as a true inflationary threat, and will continue with its rates policy, as its core inflation gauge - the U.S. PCEPI ex food and energy - continues to move higher. Over the short run, this would look like U.S. real rates are falling, boosting the appeal of gold. However, the oil-price spike plus a maintained bias by the Fed to continue raising policy rates will lift the USD TWIB, even as oil prices remain high. This will be a double-whammy to EM economies - the absolute price of oil in USD will rise significantly, even as a stronger USD raises the cost of all other dollar-denominated goods and services. This will reduce disposable income and lower aggregate demand in EM economies. Should the Fed misread the oil-price spike in a rising interest-rate environment, we believe holding gold in a diversified portfolio continues to make sense. Gold outperforms in rising inflation environments, and when demand for safe-havens increases. In addition, gold outperforms equities in periods of declining stock markets (Chart 4). This convexity on the upside and downside is one of gold's strongest attributes. Bottom Line: Given the continued pressure on gold from the Fed's rates-normalization policy, the yellow metal will remain an inexpensive portfolio hedge. Gold prices are currently below or close to their long-term average when expressed in terms of the S&P 500 or oil units (Chart 5). Hence, diverting limited amount from equity to gold is recommended on a risk-adjusted basis. Chart 4Gold V. S&P 500 Chart 5Gold Is Relatively Cheap Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Russian energy minister Novak sees broader OPEC, Russia, allies cooperation charter 'expedient' from Jan 1, 2019" published by SP Platts Global on September 11, 2018. 2 Please see "Brazil Farmers Vie For Soy Contract During U.S. - China Trade War," published by reuters.com on September 10, 2018. 3 Please see "U.S. and Saudi energy ministers to meet in Washington: DOE," and "Russia's Novak to meet with U.S. counterpart Perry, discuss oil markets," both published by reuters.com on September 10, 2018. 4 Our view is aligned with BCA's U.S. Bond Strategy, which can be found in "The Powell Doctrine Emerges" published September 4, 2018. It is available at usbs.bcaresearch.com. 5 Please see "OPEC crude oil production rises to 32.89 mil b/d in Aug as cuts unwind: Platts survey" published by SP Platts Global September 6, 2018. Noteworthy in the Platts analysis is the KSA increase to 10.5mm b/d. NB: We will be updating our balances next week. See also "U.S. warns Iran it will respond to attacks by Tehran allies in Iraq" published by reuters.com on September 11, 2018. 6 Rising secular tensions in Iraq - particularly vis-à-vis Iran's role in that state - could threaten production and exports there, as we discussed in the Special Report we published last week, in concert with BCA's Geopolitical Strategy. Please see "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply" published September 5, 2018, and "Iraq Is The Prize In U.S. - Iran Sanctions Conflict" published June 7, 2018. Both are available at ces.bcaresearch.com. 7 Civil order in Libya is collapsing. The Islamic State is increasing the tempo of its operations in and around Libya; forces loyal to the late dictator late Muammar Qaddafi staged a mass escape from a Tripoli prison earlier this month; and local militia are threatening to extend the Libyan unrest into neighboring states. Please see "Libya's Haftar threatens to 'spread war' to Algeria" reported by Arab News September 11, 2018; "Masked gunmen attack Libyan oil corporation HQ in Tripoli," published by The Guardian September 10, 2018; and "Hundreds escape in jailbreak near Libyan capital" published by The National in the UAE September 3, 2018. 8 These effects are not constant or fixed. Each period has its own specificities implying a range around the rate hike and oil-prices spike necessary to disrupt the economy. 9 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk" published August 23, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights An inflation scare would initially take bond yields higher. But the higher bond yields would undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, an inflation scare could unleash a potentially much larger disinflationary scare. And the subsequent decline in yields would exceed the original rise. Using the 10-year T-bond yield for our roadmap (because it is least impacted by the lower bound to yields) a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Feature The global long bond yield has been trapped within a tight sideways channel for almost two years (Chart of the Week); the global equity market has also lacked any clear direction in recent quarters (Chart I-2). The result is that this year's defining feature for asset-class returns is that there is no defining feature! Global equities, bonds and cash have delivered near-identical returns.1 Chart Of The WeekThe Global Long Bond Yield ##br##Has Been Trapped Chart I-2World Equities Have Drifted ##br##Sideways This Year This is not to say that 2018 has been a dull year for investors. Far from it. But all the action has been underneath the main asset allocation decision, across sectors, regions and countries. For example, European healthcare has outperformed European banks by 35 percent; and developed market equities have outperformed emerging market equities by 15 percent (Chart I-3 and Chart I-4). Chart I-3The Main Action Has Been Across Sectors... Chart I-4...And Across Regions Unshackling Bond Yields Might Be Difficult In the major developed economies, unemployment rates keep hitting new generational lows, implying that the main labour markets are tight. Yet policy interest rates range from a crisis-level negative 0.4 percent in the euro area to just 0.75 percent in the U.K. to a modest 2 percent in the U.S. This raises the potential for an inflation scare. At any moment, the bond market might panic that central banks are well behind the (Phillips) curve.2 The spike in bond yields would of course unleash a countervailing disinflationary feedback, by cooling credit growth and credit-sensitive sectors in the economy. But this feedback would take weeks or months to take effect and to show up in the economic data. Until then, it would liberate bond yields to reach higher ground. However, there would be a more powerful and immediate feedback which would keep the shackles on bond yields. That feedback would come not from the economy, but from the financial markets themselves. In Finance 101, all investment students learn that the valuations of risk-assets depend (inversely) on bond yields. But what is less well understood is that at very low bond yields this relationship becomes exponential. Approaching the lower bound of bond yields, bonds become doubly ugly. Not only do they offer feeble returns, but the bond returns take on an unattractive asymmetry. Specifically, you can no longer make a sudden large gain, but you can still suffer a sudden deep loss. In effect, bonds become much riskier investments.3 Confronted with this increased riskiness of bonds, 'risk-assets' becomes a misnomer because risk-assets are no longer riskier than bonds! This requires risk-asset returns to collapse to the feeble return offered by bonds with no additional 'risk-premium', giving their valuations an exponential uplift (Chart I-5). The big problem is that if bond yields normalise, the process goes into sharp reverse - the lofty valuations of risk-assets must decline as exponentially as they rose. Chart I-5At Low Bond Yields ##br##The Valuation Of Equities Changes Exponentially The global bond yield appears close to this crossover point at which risk-asset valuations become vulnerable to an exponential derating. In the past year, whenever the global bond yield has reached the upper limits of its recent range - defined by the sum of 10-year yields on the U.S. T-bond, German bund, and JGB reaching 3.5 percent - the correlation between bond yields and equities has turned sharply negative (Chart I-6). And the subsequent sell-off in equities has eventually pegged back the rise in bond yields, effectively trapping them. Chart I-6At Higher Bond Yields The Correlation With Equity Prices Has Flipped From Positive To Negative But what would happen if there were an inflation scare? The answer depends on the relative sizes of the inflationary impulse compared with the disinflationary impulse that resulted from sharply lower risk-asset prices. If central banks were more concerned about the inflationary impulse, they would have to keep tightening - in which case, bond yields would be liberated to reach elevated territory. Conversely, if the bigger worry was the disinflationary impulse, central banks would quickly reverse course, and bond yields would return to the lowlands. We now explain why the disinflationary impulse from lower risk-asset prices would end up as the bigger worry. An Inflation Scare Would Be Disinflationary The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets and preceded the emerging market credit boom (Chart I-7). Chart I-7The Emerging Market Boom Happened After 2008 By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes - global equities (Chart I-8), global credit (Chart I-9), and global real estate. This makes it considerably more dangerous, because we estimate that the total value of global risk-assets is $400 trillion, equal to about five times the size of the global economy. Chart I-8Elevated Valuations On Global Equities Chart I-9Elevated Valuations On Global Credit Let's say you had an investment that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today's price must surge by 63 percent.4 If you were prudent, you might amortise today's windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. Now let's imagine a valuation derating moves the investment's returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The key takeaway is that any inflationary impulse would - through higher bond yields - undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, it could unleash a potentially much larger disinflationary impulse. A Roadmap For An Inflation Scare The high sensitivity of risk-asset valuations to bond yields is the genesis of our 'rule of 4' strategy for equity allocation, which is based on the sum of the 10-year yields on the U.S. T-bond, German bund and JGB: Above 3.5 is the level to go to a neutral exposure to equities; above 4 is the level to go underweight. Today, our metric stands at exactly 3.5 (Chart I-10). Chart I-10The 'Rule Of 4' Is At 3.5 For bonds, this means that 4 on this metric is also a good level to buy a mixed portfolio of high-quality 10-year government bonds. The equivalent level for high-quality 30-year government bonds is 5.5 (using the sum of the three 30-year yields). To sum up, an inflation scare would initially take bond yields higher. But this would threaten to unleash a much larger disinflation scare, causing the subsequent decline in yields to exceed the original rise. Using the 10-year T-bond yield as an illustration - as it is least impacted by the lower bound to yields - this would suggest the following roadmap: a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The global long bond yield is captured by the simple average of the 30-year yields on the U.S. T-bond, German bund and Japanese government bond (JGB). The global equity market is captured by the MSCI All Country World Index in local currency terms. 2 The -0.4 percent refers to the ECB deposit rate. 3 Please see the European Investment Strategy Weekly Report "The Rule Of 4 For Equities And Bonds," August 2, 2018, available at eis.bcaresearch.com. 4 5 percent compounded over ten years. Fractal Trading Model* This week’s recommended trade is an intra-commodity pair trade: short palladium/long copper. The profit target is 6% with a symmetrical stop-loss. In other trades, short euro area energy versus financials was closed at the end of its 65 trading day holding period, albeit in loss. This leaves five open trades. 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 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Chart 4... Even Those That Produce Gridlock What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Chart 5B...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Chart 9Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling Chart 15Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Chart 20 Geopolitical Calendar