Financial Markets
My colleagues Caroline Miller, Peter Berezin and I broadcasted a webcast this past Wednesday to discuss the outlook for the dollar along with recent market-relevant fiscal and trade policy pronouncements. If you haven't already, I hope you find time to listen in. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights On the one hand, because the Federal Reserve targets inflation and because tariffs are inflationary, when the economy is at full employment, tariffs could lift the USD. On the other hand, investors have been conditioned to the reality that tariffs are a tool used by previous U.S. administrations to weaken the dollar. Also, tariffs bring back memories of the 1970s stagflation, a very dollar-bearish period. Tariffs also raise the risk that the USD share of global reserves declines. Even if protectionist rhetoric raises the probability of a global trade war, we do not believe the set of tariffs proposed now are the beginning of such a catastrophe. However, we remain worried that Sino-American tensions will only escalate going forward. If a global trade war were to unfold, the USD would likely suffer down the road, and EUR/JPY could get hit. The short-term impact of Sino-U.S. trade tensions should be more limited; however, the AUD would suffer from this conflict. We are closing our short CAD/NOK trade at a 4.55% profit this week. Feature Last week, U.S. President Donald Trump announced that America would be slapping tariffs of 25% on steel imports and 10% on aluminum imports. True to himself, he then proceeded to tweet that "trade wars are good and easy to win." In response to this bravado, investors began to worry about the growing risk of a global trade war - a replay of the disastrous Smoot-Hawley tariffs of the 1930s - and the USD weakened anew. This obviously begs the following questions: Are tariffs and trade wars good or bad for the dollar? What is the real likelihood of a trade war engulfing the globe? What signposts should investors monitor to judge whether the world economy is regressing to a 1930s-like nationalist period? We think the current set of proposed tariffs will have a limited impact on the USD, especially as the Fed seems increasingly dead set on tightening policy. However, we need to monitor how NAFTA negotiations evolve. A breakdown in NAFTA negotiations would indicate a rising threat of a global trade war, which down the road would threaten the reserve currency status of the USD. Intellectual property trade disputes with China are another barometer to follow, as Sino-American tensions could intensify markedly. An escalation of these tensions would likely weigh on EM and commodity currencies. The SEK could suffer as well. How Could Tariffs Help The USD? There are two competing hypotheses out there, with diametrically opposed conclusions for investors. One school of thought argues that tariffs could help the dollar; another, that it would hurt the dollar. Chart I-1No Slack In The U.S. Let's begin by exploring how tariffs could help the dollar. Last July, the IMF published an in-depth study of the dynamics that may be associated with tariffs being implemented by any economy.1 Based on the assumption of the imposition of a 10% import tariff across the board, various interesting conclusions emerged. The imposition of imports tariffs should have an inflationary impact on the economy. The first stage is a one-off adjustment with a transitory impact, reflecting the sudden upward adjustment in the price of imports proportional but not equal to the size of the tariffs. If, however, the economy is at full employment, the higher price of foreign-sourced goods incentivizes repatriation of some production onshore. This repatriation brushes up against capacity constraints in the economy's production function, lifting prices over many quarters. The U.S. economy is at full employment, with aggregate capacity utilization at its tightest level since 2005. The U.S. could experience a second-round inflationary effect if broader tariffs are implemented (Chart I-1). The most important conclusion of the IMF study relates to interest rates. Tariffs put upward pressure on domestic nominal interest rates, especially if the economy is already at full employment (Chart I-2A). This is because the central bank presumably wants to counter the inflationary impact of the tariffs. On the other hand, because import tariffs hurt foreigners' exports, the tariffs hurt foreign economies. This makes the foreign output gap more negative than it would otherwise be. In this context, U.S. interest rate differentials rise relative to trading partners (Chart I-2B). Chart I-2A & BAt Full Employment, Import Tariffs Raise Rates The IMF also explores the impact of a global trade war, where tit-for-tat behavior proliferates globally. Unsurprisingly, the IMF's models show that global output declines by roughly 1% over five years after the implementation of the original tariffs (Chart I-3A), and global trade contracts by roughly 2% of GDP over the same time frame (Chart I-3B). Chart I-3A & BGlobal Trade Wars Hurt Trade And Growth The U.S. is a relatively closed economy, as exports constitute approximately 8% of GDP compared to 20% of GDP in major European economies and 16% of GDP in China and Japan (Chart I-4). Hence, the U.S. economy is likely to experience a smaller contraction of output in a global trade war than other major economies. Moreover, as the Global Financial Crisis illustrated, when global trade contracts, economies with deep current account deficits tend to experience an improvement in their trade balance. This means that for an economy like the U.S., which sports a current account deficit of 2.3% of GDP, contracting global trade will shrink the current account deficit, further mitigating some of the negative impact on GDP. Thus, the U.S. output gap would deteriorate less than in countries sporting large current account surpluses like Germany, Japan, or China. U.S. interest rates would rise relative to the rest of the world, causing the dollar to appreciate. Bottom Line: On the one hand, when an economy is at full employment, the imposition of tariffs can generate systemic inflationary pressures. The response of an inflation-targeting central bank would be to tighten policy. This describes the U.S. today, suggesting the USD could rise if tariffs are imposed. Moreover, if a full-fledged trade war ensues, the U.S. economy's lower sensitivity to global trade would limit the negative impact relative to its more globally exposed trading partners - another plus for the dollar. Chart I-4U.S. Growth Is Less Exposed To Global Growth Chart I-5History: Trade Spats Have Hurt The Dollar But The Dollar Is Falling, So What Gives? The analysis above is theoretical, and flies in the face of the real world, where the dollar has been weakening since President Trump announced his intention to impose tariffs. This analysis relies on two words: Ceteris Paribus, and the world is anything but Ceteris Paribus. Investors are having qualms about the dollar because of the history of tariffs. As Marko Papic highlighted in a recent special client note in BCA's Geopolitical Strategy service, tariffs and the threat of tariffs are often used by U.S. administrations to force an upward adjustment in the currencies of U.S. trading partners.2 This worked very well in 1971, when Nixon imposed a 10% surcharge on all imported goods. The 1985 Plaza Accord materialized amid threats of large tariffs by the U.S. on German and Japanese exports, which made those two nations much more willing to see their exchange rates appreciate sharply against the USD. Even more recent trade spats such as the U.S.-Japan tensions in the early 1990s or President George W. Bush's steel tariffs in 2002 were also associated with a weakening dollar (Chart I-5). History has another lesson in store: Investors fear a return of stagflation. The U.S. has a populist president, and fiscal policy is becoming expansionary despite the economy being at full employment - an environment very reminiscent of the late 1960s and early 1970s (Chart I-6). Tariffs too are inflationary and hurt output. Finally, while it remains to be seen if Fed Chairman Jerome Powell will be as malleable to the White House's demands as then Fed Chairman Arthur Burns was, Powell is still perceived as an untested Trump appointee. These apparent similarities with the 1970s are prompting investors to sell the USD. Stagflation was unkind to the dollar as the DXY fell 29% from the 1971 Smithsonian Agreement to December 1979. Chart I-6Like the Late 1960's: Full Employment And Fiscal Stimulus A theoretical concept is also frightening investors: Will Trump's policies prompt a decline of the dollar's share of global reserves? The U.S. dollar is the premier global reserve currency, accounting for 63% of allocated FX reserves. However, a paper from Harvard University highlighted that the dollar is in fact over-represented in global reserves based on trade flows.3 One of the key factors explaining the large role of the USD in global reserves is that many economies have dollarized financial systems, where the greenback represents a large share of their banks' liabilities. Since many of these economies have little access to direct financing from the Fed, as a matter of precaution these nations keep many more dollars in their FX reserve pools for rainy days. If the dollar increasingly becomes a weapon used by the White House, and the U.S. also wants to shrink its current account deficit through aggressively nationalist trade policy, the supply of dollars to the global financial system will decrease and become more volatile. This will make dollar-based financial systems around the world more unstable and dangerous. In the near-term, this uncertainty may support the dollar, but over the longer-run, growing trade restrictions by the U.S. could spur countries to abandon the USD as a source of financing. If they stop financing themselves in USD, they can diversify their FX reserves away from the dollar and mitigate geopolitical risk emanating from the U.S. Chart I-7Is The Exorbitant Privilege Ending? Why is this a problem? As Chart I-7 illustrates, the U.S. has a negative net international investment position of -40% of GDP - i.e. it owes much more money to foreigners than it is owed by foreigners. Yet, the U.S. still manages to eke out a positive primary international income balance of 1.1% of GDP. This is because foreigners are willing to hold dollar bonds at derisively low rates for such an indebted nation. Foreigners are willing to do so because they want to hold dollars as reserves. If the global demand for USD reserves declines, financing the U.S.'s current account deficit and negative net international investment position will become more expensive. The simplest and fastest way to make dollar assets more attractive for foreigners is to weaken the USD today, which lifts expected returns on U.S. assets down the road. Bottom Line: On the other hand, the dollar has responded negatively to the suggestion of new tariffs. The world is not a ceteris paribus environment, and investors are worried that tariffs could plunge the U.S. economy back into 1970's style stagflation. Moreover, the weaponization of the USD decreases its attractiveness as the premier reserve currency of the world, potentially endangering a crucial source of demand for the USD. So What? Both sides of the debate make some valid arguments. But as was the case with the twin deficit, the outlook for the dollar will hinge on the Fed's response to the impact of tariffs on inflation.4 If the Fed ignores the inflationary impact of the repatriation of production onshore, then, investors are correct to replay the stagflation story of the 1970s. However, the Fed doesn't seem to be so inclined. Chairman Powell has acknowledged accelerating U.S. economic momentum, and even perennial doves like Lael Brainard have highlighted the positive impact of stronger global growth, a weaker dollar, and fiscal stimulus on the U.S. growth outlook. The Fed seems ready to hike and does not want to fall behind the curve. There is another dimension to the question. What is the likelihood that Trump tariffs are the opening salvo of a protracted trade war? To be clear, tariffs on steel and aluminum only affect 1% of U.S. imports, or 0.15% of GDP. Tariffs will only have a macro impact if they are broadened or if widespread retaliation ensues. So far, these new tariffs barely affect the long-term trend of declining obstruction to trade, and they remain a far cry from the levels hit in the 1930s (Chart I-8). So, while the probability of a global trade war has risen, it is not a base-case scenario. Instead, it remains to be seen if Trump will become much more aggressive on the trade front. Canada - the top exporter of both steel and aluminum to the U.S. - would have been the country most negatively affected by these tariffs (Table I-1). However, key allies like Canada, Mexico, Australia, Korea and the EU will be exempted from the tariffs. This does not yet point to an all-out trade war between U.S. and the rest of the entire planet. Chart I-8Steel And Aluminum Tariffs: No Smoot-Hawley Table I-1Target Is Locked, Is It? While the probability of a generalized trade war with advanced economies is low, a continued toughening of relations with China is much more likely. President Trump wants greater access for U.S. firms to Chinese markets, and is likely to apply increasing pressure in that direction. For investors, it is important to evaluate if the U.S. is pursuing isolationist policies on a global level or if the impact will be limited to the Sino-American relationship. BCA's Geopolitical Strategy service recommend investors track the following signposts: NAFTA: Marko Papic and his team see a 50% probability that NAFTA will be abrogated as Trump is constitutionally unconstrained from abrogating the deal. If the White House continues negotiating with Mexico and Canada, it increases the likelihood that the tariffs are a shot across the bow directed at China. If NAFTA is not only abrogated but if the trade relationship reverts back to WTO rules, this would signal that the U.S. will remain highly belligerent, raising the risk of implementation of a broader spectrum of tariffs. China Intellectual Property Theft: China only imports US$8 billion in intellectual property from the U.S., suggesting that large-scale theft is happening. The Trump Administration is investigating Chinese technology transfers and Intellectual property theft under Section 301 of the Trade Act of 1974. This could lead to penalties imposed on China, including tariffs, an indemnity for past IP theft, and limitations to Chinese investments in the U.S. This would constitute a massive ratcheting up in Sino-U.S. tensions. This scenario has a much higher probability than a global trade war and it would have a meaningfully negative impact on the Chinese economy, as 19% of its exports are shipped to the U.S. The inflationary impact on the U.S. would be real as well. A global trade war would ultimately hurt the dollar as it would cause the dollar's share of global FX reserves to decline. However, commodity currencies, the Swedish krona and key EM currencies would suffer as global trade contracts (Chart I-9). The yen could perform especially well in this environment, rallying even against the euro (Chart I-10). But again, we see this scenario as a tail risk, not a base case. Chart I-9Key Losers From Falling Global Trade Chart I-10EUR/JPY Could Suffer If A Trade War Materializes Meantime, a bilateral conflict with China is likely to have a more limited impact on currency markets. However, the AUD would be the big loser in such a scenario as the Australian and Chinese economies are tightly linked (Chart I-11). This is an additional reason to underweight the AUD as the probability of growing Sino-American tensions is elevated. Finally, our short EUR/SEK trade is being very negatively affected by the current environment of trade tensions, as EUR/SEK rallies when global trade recedes (Chart I-12). Since we expect tensions to decrease over the coming months, EUR/SEK is likely to weaken, ultimately. Chart I-11China's Boost Is Dissipating Australia Is Tied To The Hip With China Chart I-12SEK At Odds With Trump Bottom Line: The current set of tariffs proposed by the White House is not the beginning of a global trade war. However, it shows that the probability of such an event has grown. Since we are anticipating that the Fed will fight inflationary forces created by further tariff impositions, we are fading the dollar's recent weakness. Yet, we worry that tariffs aimed more specifically at China could become more of a focus. So while we fade the impact of tariffs on the USD, risks are building up for EM currencies and the Australian dollar. Global trade tensions are also a major headwind to the Swedish krona. Housekeeping We are closing our short CAD/NOK trade at a 4.55% profit. Our target was hit, and the exemption of steel and aluminum tariffs for Canada is a positive outcome that could at least temporarily reduce the discount imputed on the CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Linde, Jesper and Andrea Pescatori (2017). "The Macroeconomic Effects of Trade Tariffs: Revisiting the Lerner Symmetry Result." IMF Working Paper No. 17/151, International Monetary Fund. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 3 Shah, Nihar. "Foreign Dollar Reserves and Financial Stability"(2017) 4 Please see Foreign Exchange Strategy Weekly Report, "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card", dated March 6, 2018, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive for the dollar: PCE yearly inflation came in at 1.7%, outperforming expectations. ISM Manufacturing PMI and ISM prices paid both outperformed expectations, coming in at 60.8 and 74.2 respectively. Finally, unit labor costs yearly growth outperformed expectations, coming in at 2.5%. The only blip were initial jobless claims that surprised to the upside, coming in at 210 thousand. The dollar has depreciated by roughly 1.2% in the month of March so far. Overall, we continue to see upside for the dollar in the short term. However, this will be a countertrend rally within a cyclical bear market. Report Links: The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Producer price inflation came in at 1.5%, underperforming expectations. It also declined from 2.2% the previous month. Moreover, Markit services PMI AND Markit Composite PMI both underperformed expectations Finally, both the gross domestic product yearly growth and the unemployment rate came in line with expectations, at 2.7% and 8.6% respectively. After falling below 1.22, the euro has rallied by 2% in the month of March. However, in contrast to last year, data in the euro area is starting to disappoint expectations, as the effects of the tightening in financial conditions resulting from the higher euro are starting to be felt in the real economy. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Consumer confidence came in at 44.3, surprising to the downside. Moreover Markit Services PMI also surprised negatively, coming in at 51.7. However, the unemployment rate came in at 2.4%, surprising positively. It also decreased from 2.8% the previous month. Q4 2017 GDP growth was also revised up to 2.2% from 0.5%, thanks to strong capex. The yen has appreciate further in March, at one point even trading below 106 as investors were still digeseting the impact of Trump's tariffs. Overall, while we expect further upside to the yen in the current volatile environment, the BoJ will be forced to combat this strength. At 102, USD/JPY will be a buy Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: PMI construction came in at 51.4, outperforming expectations. Moreover, Markit Services PMI came in at 54.4, also beating expectations. Finally, house price yearly growth also surprised positively, coming in at 1.8% After falling at the end of February, the pound has rallied by nearly 1%. Overall we expect the upside to the pound to be limited, given that Brexit negotiations are heating up and that any potential tightening by the Bank of England is already well priced in. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Gross domestic product yearly growth underperformed expectations, coming in at 2.4% Moreover, retail sales month-on-month growth underperformed expectations coming in at 0.1%. However, company gross operating profits quarterly growth outperformed expectations, coming in at 2.2%. AUD/USD has rallied roughly 1.3% since the beginning of the month. Overall, we continue to be bearish on the Australian dollar, as the economy is still not generating enough endogenous inflationary pressures to justify hiking rates. Moreover, a slowdown in economic activity in China would also weigh on this cross. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The trade balance came in at NZD -3.2 billion, underperforming expectations. However, thanks to robust dairy prices, the terms-of-trade index outperformed expectations, coming in at 0.8%. NZD/USD has rallied by nearly 1% in the month of March. Overall, upside to the kiwi will be limited, given that this currency will suffer amid the persistence in volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Housing starts surprised to the upside, coming in at 229.7 thousand. Moreover, the Ivey Purchasing Managers Index also outperformed expectations, coming in at 59.6. However, gross domestic product quarter on quarter growth underperformed, coming in at 1.7%. The Bank Of Canada left rates unchanged on Wednesday. Overall, the Canadian interest rates curve prices the policy outlook appropriately, the CAD has now cheapened in response to the risk of a full abrogation of NAFTA. While we do agree that the risk of NAFTA being abrogated is elevated, a return to the previously standing Canada-U.S. Free Trade Agreement would have a limited impact on the Canadian economy. The downside risk to the CAD is now much more limited. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has generally been positive: The KOF leading indicator surprised to the upside, coming in at 108, and increasing from the previous month. Moreover, the unemployment rate also surprised positively, declining from 3% to 2.9%. However, retail sales growth underperformed expectations, coming in at -1.4% per annum. EUR/CHF has rallied by more than 1.5% since the beginning of the month. Overall, we expect this trend to continue, given that inflationary pressures in Switzerland are too weak for the SNB to back off from its ultra-loose monetary policy stance. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Registered unemployment came in line with expectations at 2.5%. However, it did go down from the previous month. Nevertheless, manufacturing output surprised negatively, coming in at -2%. USD/NOK has fallen by roughly 0.8% in the month of March. We are positive on the krone within the commodity currencies. This is because there are less hikes priced into the Norwegian curve than in other countries. Moreover, oil should outperform metals given than oil is less sensitive to a shock from China. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth underperformed expectations, coming in at 1.2%. Gross Domestic Product annual growth also underperformed expectations, coming in at 1.2%. However, the Manufacturing PMI surprised to the upside, coming in at 59.9. USD/SEK has been relatively flat this this month. Overall, we believe the Riksbank will be forced to lift rates in the face of rising prices. This will push EUR/SEK lower. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Chart 1Inflation Perks Up The Fed has struck a decidedly more upbeat tone in 2018. We noted last week that the Fed staff made upward revisions to its growth forecasts, and then Chairman Jerome Powell testified to Congress that "some of the headwinds the U.S. economy faced in previous years have shifted to tailwinds." So far this more optimistic outlook is borne out in the data. Core PCE inflation rose sharply in January. The annualized 6-month rate of change is back above the Fed's target (Chart 1), and the 12-month rate of change should follow once base effects kick-in in March. For our investment strategy the message is to stay the course. The re-anchoring of inflation expectations will impart another 18 bps to 38 bps of upside to the 10-year Treasury yield. How much higher yields rise beyond that will depend on how well credit markets and equities digest the less accommodative monetary environment. Stay at below-benchmark duration and be prepared to scale back on credit risk once our target range of 2.3% to 2.5% is reached by both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in February, dragging year-to-date excess returns down to +10 bps. Although last month's sell-off did return some value to the investment grade corporate space, the sector is still expensive compared to both its own history and other comparable sectors. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 11% of the time since 1989 (Chart 2). Further, in last week's report we compared breakeven spreads across the investment grade bond universe, split by credit tier.1 Our results showed that municipal bonds offer greater breakeven spreads than investment grade corporates, after adjusting for the tax advantage. We also found that Foreign Agency debt is more attractive than investment grade corporate debt in both the Aa and Baa credit tiers. Local Authority debt is more attractive in the Baa credit tier. With a less than compelling valuation case for investment grade corporates, we will start to pare exposure once our TIPS breakeven inflation targets (mentioned on page 1) are met. This week we take a preliminary step toward de-risking by adjusting our recommended sector allocation (Table 3). The adjustments were made to both increase exposure to sectors that look cheap after adjusting for credit rating and duration, and also to lower the average duration-times-spread (DTS) of the portfolio. Specifically, we downgrade Cable/Satellite, Paper, Media/Entertainment, Brokerage/Asset Managers/Exchanges and Lodging. We upgrade Supermarkets, Tobacco, Life Insurance and P&C Insurance. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 52 basis points in February, dragging year-to-date excess returns down to +97 bps. The average index option-adjusted spread widened 17 bps on the month, and currently sits at 348 bps. The 12-month trailing speculative grade default rate edged down to 3.2% in January, and Moody's projects it will fall to 2% in one year's time. The projected decline is mostly driven by the continued waning of credit stress in the oil & gas sector. Using the Moody's projection as an input, we forecast High-Yield default losses of 1.3% for the next 12 months. This means that if junk spreads are unchanged from current levels we would expect High-Yield to return 251 bps in excess of duration-matched Treasuries (Chart 3). One hundred basis points of spread tightening would translate roughly to excess returns of 661 bps, and 100 bps of spread widening would translate to excess returns of -159 bps. Though High-Yield valuation is more attractive than for investment grade corporates - the 12-month breakeven spread for a B-rated security has been tighter than it is today 28% of the time since 1995, the same measure has been tighter only 13% of the time for a Baa-rated security - we still view the potential for spread tightening in high-yield as limited. First, 130 bps of spread tightening would lead to all-time expensive valuations in the High-Yield index - using the 12-month breakeven spread as our valuation measure. Second, the higher levels of implied equity volatility that are likely to prevail in an environment with a less-accommodative Fed will also limit how far spreads can fall (top panel). MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in February, dragging year-to-date excess returns down to -25 bps. February's underperformance was concentrated in GNMA and Conventional 15-year issues, and also in 3.5% and 4% coupons. Excess returns for Conventional 30-year MBS were roughly flat, and securities with coupons above 5% delivered strong positive performance. The conventional 30-year zero-volatility MBS spread narrowed 4 bps on the month, split between a 3 bps reduction in the compensation for prepayment risk (option cost) and a 1 bp tightening in the option-adjusted spread. In last week's report we showed that the value proposition in Agency MBS is comparable to a Aaa-rated corporate bond, but is much less attractive than other Aaa-rated securitizations (consumer ABS and CMBS).2 However, MBS are also likely to offer investors more protection in a risk-off environment. Refinancing risk will remain muted as interest rates rise (Chart 4), and in past reports we showed that extension risk will likely be immaterial.3 Valuation in MBS versus investment grade corporates is less attractive than it was a month ago, owing to the recent widening in corporate spreads, but the relative spread is still elevated compared to recent years (panel 3). MBS will start to look more attractive on a relative basis as corporate spreads recoup some of their February losses. After that, we stand ready to shift some exposure from corporate bonds to MBS once our end-of-cycle inflation targets are met. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 20 basis points in February, dragging year-to-date excess returns down to +22 bps. Sovereign debt underperformed the Treasury benchmark by 108 bps on the month, Foreign Agencies underperformed by 20 bps and Supranationals underperformed by 2 bps. Local Authorities delivered excess returns of +11 bps, and Domestic Agencies performed in-line with the benchmark. The Sovereign index has returned only 9 bps in excess of Treasuries so far this year, compared to 40 bps from the Baa-rated corporate bond index (Chart 5).4 We expect this poor relative performance to continue in the months ahead as the composition of global growth shifts back to the U.S., putting upward pressure on the dollar. In last week's report we looked at 12-month breakeven spreads in each segment of the investment grade U.S. fixed income market.5 Our results showed that Sovereign debt looks expensive across every credit tier. In contrast, Foreign Agency debt and Local Authority debt offer elevated breakeven spreads. Foreign state-owned energy companies account for a large portion of the Foreign Agency index, and this sector's relative performance closely tracks the price of oil. With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.6 Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 32 basis points in February, bringing year-to-date excess returns up to +86 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined a modest 1% on the month, concentrated at the long-end of the curve. January's abrupt increase in flows into municipal bond mutual funds reversed course last month (Chart 6). Interestingly, the sudden surge and subsequent reversal in flows was mirrored by the behavior of municipal bond issuance for new capital (panel 2). This suggests that both trends were driven by changes to the federal tax code. While we remain underweight municipal bonds for now, we stand ready to shift exposure out of corporate bonds and into municipal bonds once our end-of-cycle inflation targets are met. But in the meantime, we note that municipal bonds are already quite attractive compared to corporates. In last week's report we showed that tax-adjusted municipal bond breakeven spreads are much higher than for comparable-quality corporate bonds.7 We also note that the yield differential between a tax-adjusted Aaa-rated municipal bond and an equivalent-duration A3/Baa1 corporate bond is only -19 bps (bottom panel). Historically, this yield differential turns positive near the end of the credit cycle and investors get an even better opportunity to shift out of corporates and into Munis. We expect to get that opportunity this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve rose sharply and steepened in February. The 2/10 Treasury slope steepened 4 basis points and the 5/30 slope steepened 5 bps. As a result, our recommendation to favor the 5-year bullet versus a duration-matched 2/10 barbell returned +5 bps on the month, though it is still underwater 35 bps since the trade was initiated in December 2016. As we explained in a Special Report last year, bullet over barbell trades are designed to profit from curve steepening.8 But they also depend on what is initially priced into the yield curve. Our model of the 2/5/10 butterfly spread relative to the 2/10 Treasury slope shows that the 5-year note is currently 5 bps cheap on the curve (Chart 7). Or alternatively, it shows that the 2/5/10 butterfly spread is priced for roughly 26 bps of 2/10 curve flattening during the next six months (panel 4). In other words, if the 2/10 slope steepens during the next six months, or flattens by less than 26 bps, we would expect the 5-year bullet to outperform the 2/10 barbell. The window for curve steepening is clearly closing, given that the Fed has adopted a more aggressive tightening bias. However, with inflation on the rise and long-maturity TIPS breakeven inflation rates still below levels consistent with the Fed's target, we think 2/10 flattening in excess of 26 bps during the next six months is unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 9 basis points in February, bringing year-to-date excess returns up to +84 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate fell 4 bps and currently sits at 2.21%. As we explained in a recent report, we view the first stage of the cyclical bond bear market as being driven by the re-anchoring of inflation expectations.9 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. January data show that the annualized 6-month rate of change in trimmed mean PCE jumped to 1.99% (Chart 8), and while the 12-month rate of change rose only slightly to 1.69%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Our Pipeline Inflation Indicator also suggests that inflation will move higher, as do leading indicators for both shelter and medical care inflation, as we showed in last week's report.10 ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in February, dragging year-to-date excess returns down to -16 bps. The index option-adjusted spread for Aaa-rated ABS widened 10 bps on the month and now sits at 45 bps, 12 bps above its pre-crisis low (Chart 9). The 12-month breakeven spread differential between Aaa-rated ABS and Aaa-rated corporate bonds currently sits at +13 bps, solidly above its post-2010 average (panel 3).11 Further, we noted in last week's report that consumer ABS exhibit relatively low excess return volatility.12 Although valuation is quite attractive, the evidence suggests that collateral credit quality is starting to weaken. Delinquency rates have bottomed for both auto loans and credit cards, and a rising household debt service ratio suggests they will continue to trend higher (panel 4). Banks have also noticed the deterioration in credit quality and have responded by tightening lending standards (bottom panel). Historically, tighter lending standards tend to coincide with periods of spread widening. Remain neutral ABS for now, based on still-attractive valuation relative to investment alternatives, but monitor credit trends for a signal on when to downgrade further. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in February, dragging year-to-date excess returns down to +47 bps. The index option-adjusted spread widened 4 bps on the month and currently sits at 62 bps, close to one standard deviation below its pre-crisis mean (Chart 10). In last week's report we observed that the 12-month breakeven spread of Aaa-rated non-Agency CMBS is elevated compared to other Aaa-rated sectors (consumer ABS being the exception), but that it also exhibits high excess return volatility.13 While there is no doubt that relative value is attractive, we are concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (panel 4). It is possible that tight spreads are simply foreshadowing an imminent re-acceleration in prices, and in fact bank lending standards have become less of a headwind, tightening less aggressively than in recent years (bottom panel). But for now, we think non-Agency CMBS are still not worth the risk. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +8 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 41 bps. In last week's report we noted that the 12-month breakeven spread for Agency CMBS is higher than for all other Aaa-rated sectors, except for non-Agency CMBS and consumer ABS. We also noted that the sector has historically exhibited low excess return volatility. Remain overweight. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.96% (Chart 11). The fair value was revised down by 5 bps compared to last month due to a combination of more bullish dollar sentiment (bottom panel) and a tick lower in the Global PMI (panel 3). Of the four major economic blocs, PMIs declined in the U.S., Eurozone and Japan. Only the Chinese PMI managed a slight increase (panel 4). We see the risk of a significant relapse in the U.S. PMI as quite low, but recently highlighted that weakening leading indicators in China could soon bleed into lower Chinese PMI prints.14 This is a significant near-term risk to our below-benchmark duration recommendation. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.86%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 The Baa-rated corporate index is the Sovereign sector's closest comparable in terms of average credit rating. 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies" dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 11 The breakeven spread measures the option-adjusted spread on offer per unit of duration. 12 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 13 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 14 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.
Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk
The GAA DM Equity Country Allocation model is updated as of February 28, 2018. After the large upgrade in January, the model has furthered upgraded the U.S. to a small overweight of 3.3 percentage points from neutral in January. This change is mainly financed by a reduction in the large overweight in the Netherlands. Directionally, the model is becoming more defensive in the sense that the sizes of large bets have shrunk two months in a row, as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 55 bps in February, largely driven by the Level 2 model which underperformed by 131 bps. The large underweight in Japan hurt the performance the most because in USD terms Japan was the best performer thanks to the strength of JPY versus USD. Since going live in January 2016, the overall model has outperformed the benchmark by 102 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 345 bps. The Level 1 model has performed on par with the MSCI benchmark. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2018. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The model has turned negative on cyclical sectors by sending negative signals from the growth component. Additionally, the recent correction in equity markets has also created unfavorable momentum signals. From being overweight on cyclical sectors by 10%, the model has now turned underweight by 1.3%. However, energy stocks have seen their overweight increase by 3% on the back of favorable valuations. The biggest change was an upgrade to overweight for the utilities sector on the back of the weaker growth outlook and not so negative momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Chart 1Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Chart 4Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Chart 13Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Seasonal environmental restrictions on Chinese aluminum output are due to ease going into spring, which will restore some of the output taken off line when inefficient smelters were shuttered last year. Global demand likely will slow later this year, largely because we expect GDP growth in China, which accounts for more than half of global aluminum consumption, to moderate in 2H18. In addition, expected U.S. tariffs and quotas will limit imports and revive output in that market. This will contribute to the easing of a tight global balance, and take some of the pressure off prices, but we do not expect a significant move lower. We remain neutral. Energy: Overweight. Our long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls - recommended last week on the back of our updated price forecast - closed with a 3.1% gain on Tuesday. We took profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, realizing a 20.7% gain since it was recommended January 18, 2018. Base Metals: Neutral. We are expecting a secular increase in aluminum supplies this year, on the back of Chinese environmental policies and more difficult global trading conditions. Precious Metals: Gold markets awaited Fed Chair Powell's Humphrey-Hawkins testimony beginning Tuesday, as vice chair for financial supervision, Randal Quarles, warned U.S. economic growth could exceed expectations the day before. Ags/Softs: Underweight. Argentina's drought looks like it will stress that country's grain harvests, and tighten markets at the margin. Feature Chart of the WeekAluminum In Large Deficit Last Year Easing of winter supply restrictions in China, as well as tighter controls on U.S. aluminum imports, will dominate the aluminum market in the near term. In both cases, the net effect likely will be an increase in global supply. The latter would also support aluminum's price in the U.S. market - as measured by the U.S. Midwest premium. These events will ease the global physical deficit in aluminum, which last year came in at its widest since 1995 (Chart of the Week). The current tight conditions are driven by Beijing's elimination of overcapacity, which, along with environmental reform policies implemented last year, led to a reduction in China's output. The price dynamics that dominated the aluminum market over the past couple years will shift as a result. This already can be seen in the behavior of prices on the LME and the SHFE: LME prices have been gyrating around $2,200/MT, while SHFE prices have dipped by more than 5% since the beginning of the year. Unwinding China's Supply-Side Policies? At first blush, it may not be apparent China's primary aluminum production sector experienced significant changes last year. After stalling at 1% year-on-year (y/y) growth in 2016, output grew 1.2% y/y in 2017, a sharp deceleration from the 16% y/y average growth rates registered between 2010 and 2015. However, the annual gain masked a 10% y/y increase in output in 1H17, which was almost completely reversed by the negative impacts of China's environmental policies and its efforts to eliminate overcapacity. These policy-led initiatives ultimately caused output to fall 7% y/y in 2H17 (Chart 2). The resulting 1 mm MT of production cuts in the second half of last year reflects China's 2017 supply-side policies. Beijing's strategy is two-fold: Chart 2Sharp Fall In 2H17 Output From China ... Eliminate outdated and unlicensed capacity by forcing it to close. This has removed an estimated 3-4 mm MT of annual capacity. The policy targets capacity lacking proper building and expansion permits, as well as the smelters that do not meet strict environmental standards. However, not all the shutdowns are permanent. Among this shuttered capacity is 2 mm MT of outdated smelter capacity belonging to China Hongqiao, which the company plans to replace with new capacity.1 The other major supply-side policy implemented by Beijing last year is a restriction on smelter activity during the mid-November to mid-March period. As is the case in the steel sector, this winter-curtailment policy seeks to reduce pollution during the smog-prone winter months. Aluminum smelters in the cities targeted in the winter plan were ordered to cut output by ~ 30% during this period. This policy is expected to be an annually recurring event until 2020. However, while 3 mm MT of annualized capacity would have been closed during the winter if the full 30% curtailment target had been met, reports surfaced in mid-December that compliance was low, and suggested only ~ 0.6 mm MT of capacity (just 20% of the goal, or 6% of the curtailment target) had been closed.2 The total aluminum annual capacity affected by both the winter environmental curtailments and capacity-reduction policies implemented last year could potentially reach 7 mm MT. China's total smelting capacity was a reported 40 mm MT in 2016. Lower Chinese Production ... And Consumption On a year-on-year basis, global primary aluminum production has been falling since August. This is, for the most part, true on a month-on-month basis, as well. The 12-month moving average for global aluminum production peaked in July, and has been coming down consistently since then. Although 2017 production came in higher than the previous year, this is due to a ~ 6% y/y increase in the first half, which preceded a ~ 4% y/y decline in output in the second half of the year. These dynamics are driven by China, which accounts for 55% of global primary production. Chinese firms raised primary output in 1H17, which was followed by a sharp contraction in 2H17. Chinese primary aluminum production peaked in June, recording an all-time record of 2.98 mm MT before falling in the subsequent months. On the other hand, primary production from the rest of the world has remained largely unchanged over the past two years, at 26 mm MT. Data from the International Aluminum Institute shows month-on-month production increases in China in December and January; however, output is still lower vs. the same period a year earlier. Chinese production drove global aluminum production higher in the past, but falling output from the world's leading producer now is causing global primary aluminum supply to contract. The impact of China's supply curtailments has been muted by lower demand for the metal (Chart 3). Again, lower consumption has been driven by the top-demand market - China - which typically consumes ~ 55% of the primary metal. Chinese primary consumption and production each came down by more than 1 mm MT y/y in the second half of last year. Falling aluminum demand in China is consistent with a slowdown in Chinese automobile production as well as fixed asset investments in infrastructure and transportation (Chart 4). Furthermore, China's scrap aluminum imports increased in 2H17, reflecting a preference for the secondary metal as the price of primary aluminum increased. Chart 3... Coincided With Falling Chinese Consumption Chart 4Slowdown In Chinese Demand A Divergence In Global Dynamics ... Despite the improved balance in China, the global primary aluminum balance in the rest of the world recorded a large deficit last year - the largest since 1995 (Chart 5). While both consumption and production in China came down by more than 1 mm MT in 2H17, consumption in the rest of the world increased by ~ 0.4 mm MT, even as production remained largely unchanged. This tightened the global market, as more stringent aluminum production policies in China meant that there was no flooding of Chinese aluminum to ease the deficit. In fact, the world excluding China deficit is the largest at least since the World Bureau of Metal Statistics (WBMS) started collecting data in 1995. ... Is Reflected In Inventory Dynamics This also coincides with rising aluminum stocks on the Shanghai Futures Exchange and falling inventory on the LME. In fact, Chinese aluminum imports have been falling and were down almost 30% y/y in 2H17. At the same time, Chinese net exports picked up slightly (Chart 6). Chart 5Record Aluminum Deficit Outside China Chart 6Chinese Net Exports On The Rise In response to lower output, LME inventories have been falling since 2Q14, and they continued their descent last year, ending 2017 at roughly the same level as mid-2008. On the other hand, stocks at the SHFE have been rising steeply since the beginning of last year and are at record highs (Chart 7). Whether the tight global market fundamentals will persist depends on whether China's outdated capacity cuts prove to be temporary or permanent. Chart 7Dynamics Reflected In Stock Changes U.S. Tariffs And Quotas Would Offset Tight Markets In what appears to be an effort to revive U.S. aluminum and steel production, the U.S. Commerce Department launched an investigation into these domestic industries late last year. Last month, Commerce proposed tariffs and quotas that would impact all aluminum imports with the exception of aluminum scrap and aluminum powders. There appear to be two main objectives of this investigation: 1. Increase capacity utilization in the U.S. aluminum and steel industries; and 2. Penalize China for subsidizing its aluminum sector at the expense of those in other countries. Among the Commerce proposals: 1. A 7.7% tariff on all aluminum imports to the U.S. 2. A 23.6% tariff on all aluminum imports from certain countries, while other countries would be subject to quotas equal to 100% of their 2017 exports to the U.S.3 3. A quota on all aluminum imports from other countries equal to a maximum of 86.7% of their 2017 exports to the U.S. In a memo issued last week, the U.S. Department of Defense expressed its support for the targeted tariffs (option 2 above), as well as a recommendation to postpone action on the aluminum sector. President Trump has until April 19 to make a decision on the aluminum recommendations. While he may not stick to the exact details outlined in the three options, our Geopolitical Strategists expect him to go through with implementing protectionist measures to limit aluminum imports. U.S. production of primary aluminum is at its lowest level since 1951 (Chart 8). To reach the 80% target of smelter capacity utilization envisioned by Commerce, the U.S. will have to add ~ 0.67 mm MT of supply. This represents just ~ 1.16% of world supply in 2016. Imports currently make up 90% of U.S. primary aluminum consumption. Chart 8U.S. Producers Took A Big Hit In fact, even if this amount of aluminum was supplied domestically in the U.S. last year, the world aluminum market would have remained in deficit. Furthermore, this additional supply would pale in comparison to the cuts China has already implemented in its aluminum sector last year. China's primary production in the August to December period last year came in 1.15 mm MT below the same period in 2016. Annual smelter capacity in the U.S. is estimated to be a combined 1.82 mm MT. Of this capacity, Alcoa has 0.34 mm MT of idle capacity, Century Aluminum has 0.27 mm MT, while ARG International's Missouri plant has 0.27 mm MT of idle capacity. U.S. producers have started communicating plans to restart idled capacity. According to Century Aluminum's CEO, the company's eastern Kansas operation, which shuttered more than half of its production, could ramp output at one of its smelters to full capacity of up to 0.27 mm MT by early next year. Similarly, Alcoa has committed to partially restarting production at its Warwick, Indiana, facility, which would bring 0.16 mm MT of capacity online by the second quarter of this year. However, imports are not the sole reason output in the U.S. aluminum sector is falling. High power costs also have contributed, but this is not addressed in the Department of Commerce's report. In any case, we would not be surprised to witness an increase in aluminum imports by U.S. consumers before a final decision is made. If import controls do in fact fall into place, prices in the U.S. - as reflected by the U.S. Midwest transaction premium - will likely increase. Bottom Line: Supply- and demand-side developments, mostly in China, which accounts for more than half of global production and consumption, will combine to ease a global supply deficit this year. Expected U.S. tariffs and quotas will limit imports and revive output in that market. This will take some pressure off prices, but, we do not expect levels to move significantly lower. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "China Hongqiao says to cut 2 mln T/year of outdated aluminum capacity," published on August 2, 2017, available at reuters.com. 2 Please see "Aluminum Under Pressure After China Smog Cutbacks Fall Short," published on December 20, 2017, available at reuters.com. 3 The countries noted are China, Hong Kong, Russia, Venezuela, and Vietnam. 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 Fed: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Inflation: The headwinds working against inflation are set to fade this year. The core goods and medical care sectors will lead the way, but there are even tentative signs that the deceleration in shelter inflation might start to ease. Spread Product: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Feature One byproduct of this year's increase in Treasury yields is that market expectations for the near-term path of Fed rate hikes have converged with the Fed's most recent median projection (Chart 1). At present, the overnight index swap curve is priced for a fed funds rate of 2.19% by the end of this year and 2.54% by the end of 2019. The Fed's most recent median projection calls for a fed funds rate between 2% and 2.25% by the end of 2018, and of 2.75% by the end of 2019.1 Chart 1Market Expectations Have Converged With The Fed Dots This convergence makes the next few Fed meetings particularly interesting. Will the Fed revise up its rate projections, giving the market permission to push short-dated yields even higher? Or will the Fed continue to signal three hikes this year and 2-3 more in 2019, restraining the bear market in short-dated bonds? Fortunately, last week we received a lot of information to help us answer these questions. Several FOMC members made noteworthy public remarks and the Fed released the minutes from the January FOMC meeting. What To Expect From The March FOMC Meeting The Fed's Rosy Growth Outlook The minutes from the January FOMC meeting showed a great deal of optimism about the U.S. recovery, from both the Fed staff and FOMC participants. Chart 2Substantial Stimulus In The Pipeline The minutes noted that the Fed staff submitted stronger economic projections at the January meeting than at previous meeting, noting that: [T]he forecast for real GDP growth was revised up, reflecting a reassessment of the recently enacted tax cuts, along with higher projected paths for equity prices and foreign economic growth and a lower assumed path for the foreign exchange value of the dollar. It's important to note that while these projections include the impact of recent changes to the tax code, they do not include the potential impact from the newly proposed two-year appropriations bill that is poised to pass through Congress in the next few weeks. This bill is significant with large outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. Chart 2 demonstrates how much this spending bill and the recent tax cuts have altered the growth outlook. It shows two estimates of fiscal thrust, the initial economic impulse of changes in government tax and spending policies.2 One estimate is the IMF's baseline forecast that was made before the tax legislation was passed. That estimate showed that fiscal policy would have been contractionary this year, trimming about 0.5% from GDP, and only slightly expansionary in 2019. The second estimate, which incorporates both the tax legislation and the proposed spending bill, shows that the fiscal impulse will be +0.8% this year and +1.3% next year. A major turnaround, and the most stimulative fiscal policy since the immediate aftermath of the financial crisis. Staying The Course On Inflation At the January FOMC meeting the Fed saw a presentation on the performance of different inflation models, an exercise that is particularly important given that the Fed's traditional expectations-augmented Phillips curve model was not able to explain why prices decelerated last year. The staff concluded that while the prediction errors from Phillips curve-style models have been larger in recent years than during the 2001-07 period, they were not completely out of line with history. This synchs up with our own analysis. We re-created the Fed's expectations-augmented Phillips curve model using details from a speech given by Janet Yellen in 2015 (Chart 3).3 That model certainly shows a large prediction error in 2017, but one that is not inconsistent with past errors. The message is that 2017 was not an outlier in terms of the Fed's ability to forecast inflation, but rather that inflation is quite often difficult to forecast. The Fed staff did provide a couple reasons for why inflation lagged the model's predictions last year: [S]tructural changes in the price setting for some items, such as medical care, and the effects of idiosyncratic price shocks, such as the unusual drop in prices of wireless telephone services. And also forecast that inflation would reverse course in 2018: [C]ore PCE prices were forecast to rise notably faster in 2018, importantly reflecting both the expected waning of transitory factors that held down 12-month inflation measures in 2017 as well as the projected further tightening in resource utilization. We agree with this assessment. In fact, both CPI and PCE inflation measures have formed tentative troughs in the past few months and should see further near-term upside from both the core goods and medical care components (Chart 4). Core goods inflation has still not caught up with accelerating import prices (Chart 4, panel 2) and the PPI data show a recent large jump in health-care prices (Chart 4, panel 3). Chart 3The Fed's Inflation Model Chart 4Inflation Headwinds Will Fade On medical care, research from the San Francisco Fed has shown that a major reason for lower inflation in recent years has been the slower growth of Medicare payments to physicians and hospitals as mandated by the Affordable Care Act. But these payments are also forecast to grow 2% this year, much higher than the 0.6% growth seen last year and the 0.9% growth seen in 2016.4 It is even possible that the deceleration in shelter inflation could moderate in the months ahead, given the renewed decline in the rental vacancy rate (Chart 4, panel 4). Meanwhile, we continue to expect that stronger wage growth will eventually pressure core services inflation (excluding shelter and medical care) higher (Chart 4, bottom panel). But What Are They Saying? Even though the minutes conveyed a decidedly optimistic tone with regards to both growth and inflation, Fed speakers were much more cautious last week. Philadelphia Fed President Patrick Harker said that "based on the relatively strong economy, but the continued stubbornness of inflation, I've penciled in two hikes for 2018." Atlanta Fed President Raphael Bostic said he is "comfortable continuing with a slow removal of policy accommodation" but also that "that doesn't necessarily mean as many as three or four moves per year." St. Louis Fed President James Bullard also said that 100 basis points of rate hikes in 2018 "seems like a lot." At the very least it appears that upward revisions to GDP growth forecasts are not sufficient for these three members to revise their rate projections higher. But these three members also already projected shallower paths for rate hikes than the median FOMC member (Table 1). Table 1Composition Of The FOMC More important is whether FOMC members whose projections are consistent with the median - those with a "neutral" policy bias in Table 1 - are inclined to get more hawkish. One of those members is San Francisco Fed President John Williams who said last week that "it makes sense to think about three or four rate increases in 2018." Chart 5Still Not Back To Target At the moment, the median Fed projection calls for three rate hikes in 2018, and that median will only move higher in March if four out of the six members who currently forecast three hikes this year decide to increase their dots. Given the cautious tone struck by most Fed speakers last week, we think the odds of an upward revision to the Fed's 2018 rate hike forecasts at the March meeting are low. Bottom Line: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Our own assessment is that the headwinds working against inflation are set to fade this year and that 3-4 Fed rate hikes are likely. In either case, bond yields are still biased higher given that they are still not priced for an eventual return of inflation to the Fed's target (Chart 5). Maintain a below-benchmark duration stance. Searching For Late-Cycle Value In Spread Product As we have noted repeatedly in recent reports, we anticipate that we will start to de-risk the spread product side of our U.S. bond portfolio sometime in 2018, possibly quite soon depending on the future path of inflation.5 So this week we perform a survey of investment grade spread product sectors, with an eye towards identifying sectors that look attractively valued and also present a low risk of spread widening. Our primary tool for identifying value is the 12-month breakeven spread. The 12-month breakeven spread is the basis point spread widening required on a 12-month horizon for a sector to earn zero excess returns versus a duration-equivalent position in Treasury yields.6 Table 2 shows the 12-month breakeven spread for each sector split by credit rating. Table 212-Month Breakeven Spreads By Credit Rating The first thing we notice is the attractive spreads offered by municipal bonds after adjusting for the tax advantage. In fact, for investors exposed to the top marginal tax rate, the 12-month breakeven spread on a Aaa-rated municipal bond exceeds the spread offered by a Baa-rated corporate bond. We have previously noted that when the tax-adjusted spread on a 10-year Aaa-rated municipal bond exceeds the spread offered by the duration-matched investment grade corporate bond index, it has historically been a signal that the credit cycle is very late. We are not seeing this signal yet, but it is getting very close (Chart 6). The second observation that jumps out is that USD-denominated Sovereign debt is not attractive compared to U.S. corporate debt. This is true across the entire investment grade credit spectrum. Further, Chart 7 shows that Sovereign bonds typically exhibit greater excess return volatility than U.S. corporate bonds. Chart 6Positive Muni/Corporate Spreads##br## Are A Late-Cycle Indicator Chart 712-Month Breakeven Spread Versus ##br##Excess Return Volatility We anticipate getting an opportunity to shift out of corporate bonds and into Sovereign debt at some point during the next 12 months, but expect some poor performance from Sovereign bonds first. A quicker expected pace of Fed rate hikes has historically coincided with Sovereign bond underperformance (Chart 8), and if that plays out while growth outside the U.S. starts to moderate - a risk that has been flagged by both our leading indicators for the Chinese economy and the performance of EM/JPY currency carry trades - then this would further exacerbate the underperformance of Sovereign bonds by putting upward pressure on the U.S. dollar.7 A third observation from Table 2 is that Foreign Agency bonds look very attractive, and Chart 7 also shows that the sector has historically exhibited quite low volatility. Foreign state-owned energy companies make up a large portion of the Foreign Agency index, and this sector's performance closely tracks the price of oil (Chart 9). With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.8 Local Authority bonds are also attractively valued, though to a lesser extent than Foreign Agencies, and also tend to exhibit relatively low excess return volatility. We continue to recommend an overweight position in this sector that is comprised principally of taxable municipal debt and USD-denominated Canadian provincial bonds. Chart 8Underweight Sovereigns Chart 9Overweight Foreign Agencies Finally, we notice that credit card and auto loan backed Consumer ABS offer very attractive spreads and relatively low volatility. While we retain a neutral allocation to Consumer ABS, we note that credit trends are starting to shift against the sector. Bank are now tightening lending standards on both credit cards and auto loans, and the delinquency rate has made a cyclical bottom (Chart 10). Aaa-rated non-Agency CMBS also offer an attractive breakeven spread, though this sector has historically been much more volatile. Here too we see that banks are tightening lending standards, but the tightening has moderated in recent quarters. If this continues then delinquencies could start to roll over and property prices could start to accelerate (Chart 11). We remain underweight non-agency CMBS for now, but note the tentative improvement in credit quality. Chart 10Neutral Consumer ABS Chart 11A Nascent Improvement In Credit Quality Bottom Line: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We exclude the forecast provided by the St. Louis Fed President as an outlier and calculate the median from the remaining forecasts. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percentage of GDP. 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 6 We calculate the 12-month breakeven spread as the average index option-adjusted spread divided by the average index duration. We ignore the impact of convexity. 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification