Financial Markets
Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th, 2017, available at gfis.bcaresearch.com. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. 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 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. 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, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 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 Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Feature Chart 1Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... Chart 3...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Chart 5...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Chart 7Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Chart 16...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Chart 18Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A2 Chart A3 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Highlights Market participants should be asking why yields are higher, and not worry about how much they have climbed. While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. Our U.S. Equity Strategy service downgraded small caps to neutral from overweight. Feature Chart 1The January Jobs Report Keeps The Fed##BR##On Track For Gradual Hikes This Year Last week marked Janet Yellen's final FOMC meeting and the first week in many years that the U.S. Treasury and equity markets worried about inflation. The strongest year-over-year reading in average hourly earnings in 9 years (+2.9% in January) added to the market's inflation concerns (Chart 1). The 10-year Treasury yield climbed 15 bps to 2.84%, while the S&P 500 moved lower by 2.5% as of midday on Friday, February 2. It was the worst week for the stock market since September 2016. Individual investor sentiment on the equity market has surged recently, and valuations are at extremes. However, BCA's technical indicator for U.S. stocks is not at an extreme. BCA's stance is that while the risk/reward for stocks over bonds has narrowed, it is too soon to call an end to the bull market. However, we are monitoring real yields closely. At 2.13% on Friday morning, February 2, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets should begin to worry about the Fed falling behind the curve. While the acceleration in average hourly earnings in January cements the case for continued gradual Fed rate hikes this year, inflation is not about to spiral higher. Wage inflation remains muted, and patience is still required as market participants await signs of a pickup in broader measures of consumer price inflation. The market is now fully priced for three rate hikes this year. Also, longer-term rate expectations have moved close to the Fed's estimate of the terminal rate. It would be reasonable to expect some short-term pause to recent near-relentless uptrend in rate expectations. For the market to price tightening beyond the Fed's dots, the economy and inflation would need to outperform the Fed's forecasts (which are 2.5% GDP growth, 1.9% core inflation and 3.9% unemployment for 2018). For now at least, it's not clear that is the case. Why Rates Are Rising Matters The relentless increase in 10-year Treasury yields spooked investors early last week, but it is too soon for equity investors to worry about an overly aggressive Fed. At 2.84%, the 10-year Treasury yield is above the FOMC's view of the neutral Fed funds rate, and has moved nearly 80 bps higher since early September. Market participants should be asking why yields are higher, and not worry about how much they have climbed. Chart 2Breaking Down The Rise In Yields BCA's U.S. Bond Strategy service noted in mid-January1 that in the current environment, it is useful to split the nominal 10-year yield into its two main components - the compensation for inflation protection and the real yield (Chart 2). The 10-year TIPS breakeven inflation rate has moved from 1.66% last June to 2.13% late last week, but is still too low. Historically, the 10-year TIPS breakeven rate has traded in a range between 2.4 and 2.5% when inflation is well-anchored near the Fed's 2% target. BCA's stance is that inflation will move back to the Fed's target soon. The implication is that there is still another 25 to 35 bps of upside in the 10-year breakeven rate. The reason why this threshold is important is because a rise in inflation expectations to that level would be a signal that the FOMC will need to become more aggressive in slowing economic growth. This could occur even if actual inflation is below the 2% target, as long as it is rising toward the target. This will be especially true if the unemployment rate is heading to 3.5%, as we suspect. BCA's U.S. Bond strategists' model of real yields2 projects that real yields will rise 4 bps by the end of the year to 0.61%, but it could be more depending on how quickly the Fed wants to slow growth. Bottom Line: BCA expects that the nominal Treasury yield should move into a range between 3.0 and 3.25% by the time inflation reaches the Fed's target. BCA's stance is that risk assets will get into trouble once inflation expectations rise above 2.4%. Bond yields will presumably be moving higher along with inflation expectations. However, investors should not ignore higher Treasury yields rates. That said, equity investors do not need to be too concerned until inflation expectations hit that 2.4% threshold. Inflation itself may not be at 2% as this occurs, but if inflation is climbing and the unemployment rate is still falling, then the market will believe that the Fed is behind the curve. That is a bearish environment for equities. Inflation: Still A Waiting Game While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Chart 3 illustrates various measures of wage inflation. Panel 1 shows that the Employment Cost Index (ECI) is in a clear uptrend. The acceleration in the wages and salaries component of ECI is broad-based across geography and industry (Chart 4, panel 1). Moreover, at 86%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 4, panels 2 and 3). Chart 3Most Wage Metrics Are Rolling Over Chart 4The Employment Cost Index Is In A Definitive Uptrend... Although the year-over-year increase in average hourly earnings accelerated to 2.9% in January, many other wage indicators have stalled out recently (Chart 3, panel 4). The Atlanta Fed Wage Tracker rolled over recently along with weekly usual earnings (Chart 3, panels 2 and 3). In short, despite a robust global economy, a U.S. economy running above its long term potential and the unemployment rate (4.1% in January) below NAIRU (4.6%), labor shortages are not yet strong enough to push up wage inflation. Chart 5Shift Towards Service Economy Led##BR##To Shift Away From Capacity Utilization That said, the historical evidence suggests that once the labor market tightens, inflation eventually does accelerate. However, wages do not always lead inflation at bottoms and may be a lagging indicator in this cycle.3 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. BCA recommends that investors should monitor a broad range of inflation indicators. Most of these indicators show that inflation pressures are building, but only gradually. The low readings on manufacturing capacity utilization suggest low odds of a rapid acceleration in inflation. Furthermore, the shift in composition of the U.S. economy in the past three decades suggests that the metric is no longer an accurate measure of wage or price bottlenecks in the economy (Chart 5, panels 1 and 2). Manufacturing capacity utilization hit a post WWII low in mid-2009 at 63.5%, before recovering to a well below average 75%-76% range for the past half-decade. In December 2017, utilization hit a 9-year high at 77%. Chart 5, (panels 3 and 4) shows that prior to 1980, inflation accelerated and the output gap closed as utilization breached 80%. Since early 1990s, the relationship is not as clear. Is 5% The Magic Number On Rates? History suggests that rising rates are not an impediment to higher stock prices, as long as rates remain below 5%. Chart 6 is a reminder that the 10-year yield and stock prices climbed together in the 1950s. The rise in yields in the 50s primarily reflected better economic growth rather than fears of inflation. Nonetheless, investors are concerned that a rise in yields will flip the positive correlation between bond yields and stock prices. Table 1 shows that since 1980, long treasury yields and stock prices move in the same direction until the 10-year moves above 5%. Chart 7 shows the relationship between the level of nominal bond yields and stock to bond yield correlations back to 1874. Moreover, since 1980, a move from 2 to 3% on the 10-year is accompanied by an average gain for the S&P 500 of 1.2%, with a median move of 1.8%. On average, the S&P 500 posts a modest decline (24 bps) as the 10-year Treasury elevates from 3 to 4%, but the median return (98 bps) is still positive. Our July 2016 Special Report provides an in-depth discussion of the impact of rates and inflation on equity prices. Historically, even the move from 4 to 5% on the 10-year is not an impediment to higher stock prices.4 Moreover, in a 2016 report our Global ETF Strategy service provides a detailed overview of equity returns in various phases of the Fed cycle.5 Chart 6Stock Can Rise##BR##With Bond Yields Table 13-Year Correlation* Between Stock Prices##BR##And Bond Yield Level (1980-2018) BCA's stance is that the stock-to-bond ratio will climb this year. However, the risk/reward embedded in that stance has shifted given the move in both bond yields and stock prices in the past few months. Our U.S. bond strategists peg fair value for the 10-year Treasury yield at 3.0%, just 18 bps above the yield last Friday morning. Chart 8 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (3.0%). Our analysis assumes a 1.75% annualized dividend yield on the S&P 500. Panel 1 illustrates that the ratio between now and mid-year will remain positive if stocks are flat. The same holds true though September 2018 and year end. Just a 5% drop in the S&P 500 by year-end 2018 signals a localized peak in the stock-to-bond ratio. Declines of 10 or 20% indicate a reversal of the uptrend in stocks versus bonds that has been in place since early 2016. Chart 7Stock To Bond Correlations Remain Positive With Nominal Yields Below 4.25% Chart 8Scenarios For Stock-To-Bond Ratio Bottom Line: BCA's view is that Treasury yields will top out at around 3 to 3.25% in this cycle, as inflation returns to the Fed's 2% target. Our base case is that stocks will do well in 2018, and will not be subject to concerns over an aggressive Fed until 2019. However, investors should closely monitor the 10-year TIPs spread, as noted above. We do not expect to breech 2.4% this year, but the timing is unclear. Moreover, we may take profits on our overweight stance well before the market senses the Fed is behind the curve, earlier than that, especially given stretched valuation and stretched market sentiment. Seismic Sentiment Shift Rising rates are not the only concern for U.S. equities. In late November, we noted6 that our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators, and investors should monitor both for signs of an equity sell-off. These indicators have become even more stretched since we highlighted them in November and more clearly since the most recent equity market lull in late August 2017. BCA's technical indicator deteriorated since our late November report, but remains below levels that, in the past, have preceded bear markets (Chart 9, panel 1). The S&P 500 is testing the top end of the recovery trend channel in place since 2009 (Panel 2). A break above that level suggests more upside to stocks. However, a definitive failure to breakout may signal a period of consolidation for equities. BCA's equity valuation metric pushed further into extreme overvalued territory. Stretched valuations say more about medium- and long-term returns than near-term performance.7 However, the shift in the equity sentiment indicators we track is notable. BCA's investor sentiment composite index is at an all-time high (Chart 10, panel 1). Moreover, the surge in sentiment is led by individual investors and advisors who serve them (panels 2 and 4). Traders are a bit more complacent. Furthermore, individuals' optimism toward stocks is at an all-time high in surveys conducted by the Conference Board and the University of Michigan (Chart 11, panels 1 and 2). Chart 9Technical Picture For##BR##Equities Still Looks OK Chart 10Investor Sentiment##BR##Is Flashing Red Chart 11Surge In Consumer Optimism##BR##Toward Year Ahead Returns For Equities A similar survey from Yale University suggests that consumers' expectations about future equity market returns remains subdued. However, this may be due to the fact that the Yale survey is only available to December, and thus misses the equity 'melt up' in January that followed the news of the U.S. tax cuts. The other surveys mentioned are up to January. Notably, the Yale panel includes wealthy individual investors and a sample of institutions. The respondents in the Michigan and Conference Board surveys are more representative of the average U.S. household. Despite elevated attitudes toward equities, readings from the Fed's Flow of Funds on household ownership of stocks suggest that individuals may still have room in their portfolios for equities. Chart 12 shows that as of Q3 2017, equity holdings as a share of total household financial assets remains below prior peaks. As the U.S. stock market soared in the late 1990s, equities accounted for 31% of assets at the peak. Just before the global financial crisis, the figure was 23%. Today, equities account for just 25% of households' financial portfolios. The bottom panel of Chart 12 illustrates that individuals have allocated away from debt securities in the past half-decade. Chart 12Household Holdings Of Equities Still Below Prior Peaks Bottom Line: Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. While we are sticking with our stance that stocks will beat bonds in 2018, we are concerned about small caps. BCA's U.S. Equity Strategy service notes8 that rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth, signal that the time is right to shift from overweight to neutral on U.S. small caps. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Long And Short Of It", published January 23, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "Ill Placed Trust?", published December 19, 2017. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst "Monthly Report", published September 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global ETF Strategy Special Report "Equity Factors And The Fed Funds Rate Cycle", published December 21, 2016. Available at getf.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Technically Speaking", published November 27, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Global Asset Allocation Special Report "What Returns Can You Expect?", published November 15, 2017. Available at gaa.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?", published January 22 , 2018. Available at uses.bcaresearch.com.
Highlights Global equities are technically overbought, making them highly vulnerable to a correction. The cyclical picture for stocks still looks good, thanks to strong economic growth and rising corporate profits, but the recent spike in bond yields is becoming a headwind. Valuations are highly stretched, particularly in the U.S. This points to subpar long-term returns. On balance, we recommend staying overweight global equities. However, investors should consider buying some insurance against a market selloff. The VIX has probably bottomed for this cycle and high-yield spreads are unlikely to move much lower. This makes long volatility and short credit positions attractive hedges. Going short AUD/JPY is also an appealing hedge, given the yen's defensive characteristics and the Aussie dollar's vulnerability to slower Chinese growth. We were stopped out of our long global industrials versus utilities trade for a gain of 12%. We are also raising our stop on our short fed funds futures trade to 70 bps. Feature A Cloudy Picture As a rule of thumb, technical factors drive stocks over short-term horizons of one-to-three months, business cycle developments and financial conditions drive stocks over horizons of one-to-two years, and valuations drive stocks over ultra long-term horizons of five years and beyond. Occasionally, all three sets of signals line up in the same direction. In March 2009, the combination of bombed-out sentiment, cheap valuations, green shoots in the economy, and the expansion of the Fed's QE program all aligned to mark the beginning of a powerful bull market in stocks. Unfortunately, today the calculus is not so simple. Stocks Are Technically Overbought Technically, the stock market has gotten ahead of itself. The S&P 500 Relative Strength Index hit a record high earlier this week, while our Technical Indicator reached a post-recession high (Chart 1). The S&P has now gone 310 days without a 3% drawdown and 402 days without a 5% drawdown - both records (Chart 2). Chart 1U.S. Equities Are Technically Overbought Chart 2It's Been A Long Time Since U.S. Stocks Corrected Irrational exuberance is back. Our Composite Sentiment Indicator has jumped to the highest level since right before the 1987 crash (Chart 3). Retail investors are also flooding back into the market. Discount brokers such as E*TRADE and Ameritrade have seen a flurry of activity (Chart 4).The latest monthly survey conducted by the American Association of Individual Investors showed that respondents had the largest allocation to stocks since 2000 (Chart 5). Chart 3Equity Investors Are Mega-Bullish Chart 4Retail Investors Have Piled In (Part I) Chart 5Retail Investors Have Piled In (Part II) The Economy And Earnings Still Paint A Bullish Backdrop Chart 6Economic Outlook Remains Solid In contrast to the ominous technical picture, the cyclical outlook for stocks looks reasonably solid (Chart 6). The Citigroup Economic Surprise Index for major advanced economies has risen to near record-high levels. Goldman's Global Current Activity Indicator stands close to a cycle high of 5%, up from 2.2% at the start of 2016. Our Global Leading Indicator has decelerated somewhat, but is still pointing to above-trend growth this year. Growth in the euro area remains strong. The economy grew by 2.5% in 2017, the fastest pace since 2007. U.S. growth is gathering steam. Real private final demand increased by 4.6% in Q4. The Atlanta Fed's GDPNow model is signaling growth of 5.4% in the first quarter, while the New York Fed Staff Nowcast is pointing to a more plausible growth rate of 3.1%. Reflecting the strong economy, corporate profits are ripping higher. 45% of S&P 500 companies have reported 2017 Q4 results. 80% have beaten consensus EPS projections, above the long-term average of 69%. 82% have beaten revenue projections, which also exceeds the long-term average of 56%. The fact that earnings and revenue have surprised so strongly to the upside is all the more impressive given the sharp increase in EPS estimates over the past few months (Chart 7). Moreover, the improvement in earnings has been broad-based across sectors (Table 1). Chart 7Analysts Scramble To Revise 2018 Earnings Estimates Higher Table 1Estimated Earnings Growth For 2018 Financial Conditions Are Supportive, But Rising Bond Yields Are A Risk Financial and monetary conditions remain accommodative, as judged by an assortment of financial conditions indices (Chart 8). The global credit impulse has surged (Chart 9). Chart 8Financial Conditions Have Eased Chart 9Global Credit Impulse Is Positive The recent rapid ascent in global bond yields complicates matters. So far, much of the increase in yields has been driven by higher inflation expectations. This has kept real yields down. Indeed, real 2-year yields have actually declined in the euro area and Japan over the last several months. In absolute terms, yields are still low by historic standards (Chart 10). As my colleague Doug Peta, who heads our Global ETF Strategy service, has documented, rising bond yields pose a bigger problem for the economy and risk assets when they move into restrictive territory (Table 2). We are not there yet (Chart 11). Stronger global growth and diminished spare capacity have pushed up the pain threshold for when rising bond yields begin to bite. In the U.S., fiscal stimulus and a cheaper dollar have also caused the neutral rate to rise. Chart 10Yields Are Still Low ##br## By Historic Standards Table 2Aggregate Real S&P 500 Returns ##br## During Rate Cycle Phases From August 1961 Chart 11Rates Not Hurting ... Yet Nevertheless, equities often struggle to digest rapid increases in bond yields. Although the late 2016 episode stands out as an exception, stocks have typically floundered following an increase in global bond yields of around 50 bps (Table 3). The yield on the JP Morgan Global Government Bond index has risen by 27 bps since last autumn. If yields continue their swift ascent, stocks could come under pressure. Table 3What Happens When Bond Yields Spike? Valuation Concerns Chart 12Demanding U.S. Valuations Point To Low Long-Term Returns Valuations are not much use for timing the stock market, but they are the most important driver of returns over the long haul. Chart 12 shows the close correlation between the Shiller P/E ratio in the U.S. and the subsequent 10-year total return for stocks. Even though realized earnings growth tends to be higher following periods when the P/E ratio is elevated, this is more than offset by a lower dividend yield and the compression of P/E multiples. Today's Shiller P/E ratio of 34 presages subpar returns over the next decade. The picture is somewhat better outside the U.S. Our composite valuation measure - which combines trailing P/E, price-to-sales, price-to-book, Tobin's Q, and market capitalization-to-GDP - suggests that most stock markets outside the U.S. will see returns in the low-to-mid single-digit range over the next ten years (Appendix 1). Nevertheless, this is still well below the historic average return for these markets. What To Do? Our cyclical overweight in global equities has worked out well, and barring evidence that the global economy is tipping into recession, we intend to maintain this recommendation. Nevertheless, the discussion above suggests that stocks are vulnerable to a near-term correction and that long-term returns are likely to be lackluster at best. As such, it is sensible to take out some insurance against a market selloff. The question, as always, is how to guard against a drop in equity prices without suffering too much of a drag if global bourses continue to grind higher. We noted three weeks ago that today's equity bull market is starting to look increasingly like the one in the late 1990s.1 Back then, rising equity prices were accompanied by both higher volatility and wider credit spreads (Chart 13). History seems to be repeating itself. The VIX bottomed on November 24 at 8.56 and ended last week at 11.08, even as the S&P 500 hit another record high. Investors should consider buying volatility futures on any major dip in the VIX. Junk bonds have also underperformed equities year-to-date, which has benefited our long S&P 500/short high-yield credit recommendation. As we go to press, the Barclays high-yield total return index is flat for the year, while the S&P 500 has gained 5.7%. Given the deterioration in our Corporate Health Monitor, and the likelihood that rising inflation will keep Treasury yields in an uptrend, investors should consider hedging equity risk by shorting junk bonds. Chart 13Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Chart 14Chinese Growth Is Decelerating Moderately Go Short AUD/JPY Chart 15Iron Ore Stockpiles Are Hitting New Highs In China Going short the Australian dollar versus the Japanese yen is also an appealing hedge against a broad-based retreat from risk assets. The yen is a highly defensive currency. Japan has a healthy current account surplus of 4% of GDP. Its accumulated foreign assets outstrip foreign liabilities by a whopping 65% of GDP. When Japanese investors get nervous about the world and start repatriating funds back home, the yen invariably strengthens. The Aussie dollar is highly levered to the Chinese economy. While we do not expect a steep deceleration in Chinese growth this year, we do think that growth will fall from last year's heady pace. This can already be seen in the deterioration in the Li Keqiang index (Chart 14). The growth rate of railway freight, one of the index's components, has fallen from above 20% in early 2017 to -1%. Crucially for Australia, iron ore stockpiles in Chinese ports are hitting record highs (Chart 15). Meanwhile, the Reserve Bank of Australia's commodity index has rolled over. The year-over-year change in the index has dropped from a high of 47% six months ago to -1%. Domestically, the output gap stands at 2% of GDP. Both core CPI inflation and wage growth remain subdued (Chart 16). The household saving rate has dropped to 3%, while debt levels have reached nosebleed levels (Chart 17). This will limit consumer spending. Business confidence has dipped recently, as has the PMI new orders index (Chart 18). Mining capex has been trending lower, falling from over 6% of GDP in 2012 to 2.1% of GDP in 2017. The Australian government expects mining capex to sink further to 1.3% of GDP in 2018 (Chart 19). All this will limit the RBA's ability to hike rates. Chart 16Australian Core CPI Inflation And Wage Growth Remain Subdued Chart 17Australian Household Debt At Unsustainable Levels Chart 18Australia: Business Confidence And Orders Have Dipped Chart 19Mining Capex To Fall Further From a valuation perspective, AUD/JPY currently trades at a 27% premium to its Purchasing Power Parity exchange rate, having traded at a discount of as much as 50% back in 2000 (Chart 20). Speculators are heavily short the yen right now. As my colleague Mathieu Savary has noted, this could supercharge any short covering rally.2 Higher asset market volatility should also weaken the Aussie dollar. Chart 21 shows that AUD/JPY tends to be inversely correlated with the CVIX, an index of currency volatility. Chart 20AUD/JPY Trading At A Premium Chart 21Higher Vol Will Weaken AUD With this in mind, we are opening a new tactical trade recommendation to go short AUD/JPY. As a housekeeping matter, we are closing our long AUD/NZD trade for a loss of 1.8%. We were also stopped out of our long global industrial stocks versus utilities trade for a gain of 12%. Lastly, we are raising our stop on our short fed funds futures trade to 70 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Will Bitcoin be Defanged," dated January 12, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!," dated January 12, 2018, available at fes.bcaresearch.com Appendix 1 Chart A1Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S.Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 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 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The GAA DM Equity Country Allocation model is updated as of January 31, 2018. The model has made large shifts in country allocations. The U.S. is upgraded to neutral from previously the largest underweight, driven largely by technical conditions. It seems dramatic, but as shown in Chart 2, the model did have similar large shifts in the past as well. Canada also has received a large increase to overweight driven by extremely attractive valuation. To fund these upgrades, the previously largest overweight in Italy is cut in half (mainly driven by liquidity and valuation) and Australia is back to underweight (trading places with Canada). As a result, the model now is overweight the Netherlands, Italy, Germany, Canada and Spain, neutral on the U.S. and underweight Japan, the U.K., France, Australia and Sweden as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 99 bps in January, largely driven by the Level 2 model which outperformed by 207 bps, thanks to the underweights in the U.K., Japan and Canada vs. the overweights in Italy, the Netherlands and Germany. Since going live in January 2016, the overall model has outperformed the benchmark by 190 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 570 bps. The Level 1 model has performed in line with the MSCI world benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) 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 January 31, 2018. The model continues to be bullish on global growth as seen by a 10% aggregate overweight in the cyclical sectors. The model continues to hold equal underweights in consumer staples, health care, telecom and utilities stocks. Looking forward, we believe improving global growth dynamics, and rising equity markets will help us maintain an aggregate cyclical pro-growth bias. 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. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com