Financial Markets
Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? Chart I-2China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Today, we are sending out a previously scheduled Special Report, highlighting our thoughts on the how to assess the impact of China on global bond markets. This is an important topic that we hope you will find of great interest. We will not be offended, however, if that report sits in your inboxes for a day or two while the world awaits the results of today's U.S. Presidential election. Feature Global financial markets have been subject to extraordinary volatility over the past couple of weeks as the election campaign has drawn to a close. Investors have had to deal with the steady inflow of shifting poll results, overbearing media punditry, surprising FBI letters and wild conspiracy theories, all while trying to price the risks associated with two of the most polarizing presidential candidates in U.S. history. The recent narrowing of Hillary Clinton's lead in the polls has forced investors to seriously consider the possibility of a President Donald J. Trump, with all the change from the status quo that he represents. Given how markets have reacted to Trump closing the gap with Clinton - falling equity prices, higher volatility, lower bond yields and a weaker U.S. dollar - a Trump win could trigger a true risk-off market rout, with global investors wanting to avoid been burned by another political surprise after Brexit. Our colleagues at BCA Geopolitical Strategy still view a narrow Clinton victory as the most likely outcome, with admittedly lower conviction levels than usual for such an important election. Such is the problem of making predictions when polls are within margins of error. However, given the well-understood realities of the U.S. Electoral College map and the still-uphill climb needed for Trump to win, the result that would catch investors most off-guard would be The Donald pulling off the upset. From our perspective at BCA Global Fixed Income Strategy, a Clinton victory would keep the global economy on its current positive growth track in the near-term. This would shift bond investors' focus back over to the Fed and a likely December rate hike. However, a risk-off market move after a Trump win would represent the biggest risk to our current portfolio recommendations: We are positioned for rising global bond yields via an overall below-benchmark duration stance, given our view that we are in a cyclical growth upturn that is also pushing global inflation higher (more details on China's contribution to that can be found in the Special Report sent out today). In terms of regional bond allocation, we are favoring the areas with the lowest inflation rates and most credible dovish central banks, via an above-benchmark tilt in core Europe and a neutral stance on Japan and Canada. We are underweight the countries where central bankers are either in the process of raising rates (the U.S.) or will soon face a decision to tighten policy in the face of strong growth and rising inflation pressures (the U.K., Australia). We are also underweight Peripheral European debt (Italy, Spain, Portugal) versus Germany due to our concerns over decelerating growth in the Periphery combined with the ongoing stresses on Euro Area banks. We are overweight inflation protection (via linkers and CPI swaps) in the U.S. and U.K. where we see the greatest potential for rising inflation expectations. Within global credit markets, we are maintaining a defensive stance via underweights in U.S., Euro Area and Emerging Markets High-Yield (which are all overvalued and overlevered). Within Investment Grade corporates, we are only maintaining a neutral stance in the U.S. and above-benchmark tilts in the Euro Area and U.K. We are also neutral on Emerging Market hard currency debt, both sovereigns and corporates. In the event that Trump pulls out the win tonight, we would expect our overall below-benchmark duration call to suffer if bond yields declines in a risk-off move. However, our "break-even" level on that call allows some cushion to stick with the underweight, as we initiated the recommendation back in July when the 10-year U.S. Treasury yield was just below 1.60%. A return to those levels would be a 25bp decline from yesterday's closing level of 1.83%, which would be a massive move if it happened in a short period of time immediately after Trump was declared the winner. Yet if such large move in yields were to occur, it would almost certainly be in the context of a rout in global equity markets. Our underweight stance on high-yield corporates and Peripheral Europe would perform very well there. Our generally cautious stance on higher-quality corporates and Emerging Markets would likely cause minor hits only via our overweights in Europe, but with those markets supported by the ongoing central bank buying by the ECB and Bank of England, the losses should be relatively well-contained. There is also a risk that our overweights in inflation protection in the U.S. and U.K. would underperform, especially if the market rout turns into a lasting shock to global growth and inflation expectations. That will be difficult to determine in the immediate aftermath of a Trump win. Summing it all up, there are enough offsetting positions within our recommended portfolio to not suggest any changes into tonight's election. Let us hope that the election result is decisive enough that a winner can be declared tonight and this period of U.S. political uncertainty can end, whoever wins. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product
Highlights Chart 1Targeting 2% The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, 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 Bank profits are unlikely to match those of the broad market if the Fed hikes interest rates and loan demand cools. Sell into strength. Gold shares are looking increasingly attractive, but we will refrain from upgrading until the U.S. dollar is closer to a peak. Drug pricing power is worse than government data suggests, warranting a downshift in our previously upbeat view toward pharmaceutical equities. Recent Changes S&P Health Care - Removed from our high conviction list. Upgrade Alert Gold Shares - Currently neutral. Downgrade Alert S&P Pharmaceuticals Index - Currently overweight. S&P Biotech Index - Currently overweight. Table 1 Feature Chart 1From Greed To Fear The gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. Indeed, investors have been scrambling to buy protection, aggressively bidding up near-term VIX contracts, especially relative to longer-term contracts. While it is tempting to view this increase in fear as a contrary positive, this measure typically sinks lower when investors turn cautious. Chart 1 shows that tactical broad market vulnerability still exists. On a more fundamental basis, the non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years (Chart 2). Yet the median price/sales and price/earnings ratios are flirting with all-time highs (Chart 2). That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap. Third quarter earnings have failed to impress thus far, keeping the equity market locked in a tight range. So far, one nascent trend is that domestic and consumer-linked equities appear to be gaining traction at the expense of global, business-dependent sectors. We expect the complexion of earnings contributions to become more lopsided in the quarters ahead, in support of most of these budding trend changes. The inevitable upshot of a strong U.S. dollar is deteriorating profit breadth. Chart 3 shows that the number of industry groups experiencing rising forward earnings estimates is likely to erode as the currency strengthens. Clearly, industries most reliant on exports and/or capital spending are most vulnerable. The corporate sector has run up debt levels and is struggling to generate profit growth. In turn, business spending has been compromised, as measured by the contraction in core durable goods orders (Chart 3). On the flipside, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salary growth is underpinning real median household income. The latter surged 5.2%, posting the largest percentage increase in the history of the data. Consumer income expectations are well supported (Chart 3, top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance, even if the labor market slows. From an investment theme perspective, the upshot is domestic-oriented areas are poised to make a comeback relative to globally-exposed sectors after a burst of speed in recent months (Chart 4). Net earnings revisions are already shifting in that direction, with more upside ahead based on U.S. dollar strength, as well as dirt cheap relative valuations (Chart 4). Chart 2A Disturbing Mismatch Chart 3Consumers Are Stronger Than Corporates Chart 4Favor Domestic Vs. Global One exception is the banking sector, where there is limited scope for earnings outperformance and/or valuation expansion. Bank Stocks Are Showing Signs Of Life, But... Bank stocks have moved higher, following the sell-off in global bond markets and steepening in yield curves sparked initially by the Bank of Japan's curve targeting shift and a reversal of incremental easing expectations from the Bank of England. However, we are not convinced that the relative performance bear market is over. A Special Report published on October 3 surveyed the performance of banks during Fed tightening cycles, to help put context around the widely held view that Fed rate hikes will bolster bank stocks on a sustained basis. History shows there has been only a loose relationship between the Fed funds rate and net interest margins. It would take rising rate expectations within the context of a steeper yield curve, improving credit quality and rapid loan growth to justify an optimistic profit outlook. Bank profits have not been able to outpace the broad corporate sector since the beginning of 2015 (Chart 5, top panel), even though loan growth has been healthy and overall earnings were crushed by the implosion in commodity prices during that period, allowing most other sectors to show earnings outperformance. Will another 25 bps interest rate hike remedy this? The Fed is keen to hike rates partially because it views them as being overly accommodative for an economy operating close to full employment, and is keen to reestablish firepower in advance of the next economic downturn. But there is scant evidence of economic overheating to support the view that rates have been 'too low'. Inflation and inflation expectations, while up from very depressed levels, are still historically low and the economy is struggling to grow at, let alone above, trend. Consequently, a strident Fed would boost the odds of a policy mistake. The market appears to share that view, given the failure of the yield curve to stop narrowing since the taper talk started, notwithstanding the recent blip up (Chart 5, bottom panel). Chart 5Why Would Bank Profits Outperform Now? Chart 6Beware U.S. Dollar Strength Now that the USD is strengthening anew, the odds of imported deflation have climbed, to the detriment of corporate profits and bank stock relative performance (Chart 6, top panel). While nominal yields have backed up, real 2-year yields have declined, which is not consistent with an upgrading in economic expectations. Indeed, C&I loan growth has dropped sharply in recent weeks (Chart 6). By extension, it is hard to envision long-term yields rising much, if at all, which will keep net interest margins thin. Furthermore, if overall earnings remain stuck in neutral, corporate credit quality will undoubtedly worsen given the debt binge in recent years. Non-performing loans have only just begun to increase. Higher interest rates will not solve these problems. Instead, the downturn in credit quality could accelerate via more onerous debt servicing requirements, given the lack of a corporate sector balance sheet cushion. Perhaps more worrying is that banks are no longer pruning cost structures, which is unusual given that credit standards are tightening on most credit products outside of traditional mortgages. In the last 25 years, or as far back as we have the data, bank stocks lagged the broad market after bank employment started rising. The only exception was in the aftermath of the tech bubble, when all non-TMT sectors outperformed (Chart 7). If banks continue to expand their wage bill, without a widening in net interest margins and/or reversal in increased loan loss reserving, bank profits will fail to match the growth rate of the overall S&P 500. The optimal, but not exclusive, time for banks to outperform is typically exiting recession, when policy is easing and the yield curve is steepening, and in the late innings of an expansion. In fact, productivity is sagging throughout the financial sector. Financial sector employment is probing new highs (Chart 8), reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales, a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. Chart 7Beware Rising Bank Employment Chart 8Sectoral Productivity Drain Bottom Line: Strength in bank stocks is a chance to sell. Is It Time To Buy Back Gold Shares? Gold shares are bouncing after having been punished in the last few months. Overheated technical conditions and prospects for a more hawkish Fed led us to recommend taking profits in August, despite a positive long-term outlook. Indeed, the likelihood of a prolonged period of negative to ultra-low real interest rates is high given startlingly low potential GDP growth in most of the developed world. Gold shares typically do well in the aftermath of a debt binge, as proxied by our Corporate Health Monitor (CHM, shown advanced, Chart 9). It is unnerving that the CHM has suffered such a broad-based deterioration without any back up in interest rates. Low interest rates and tight credit spreads have cushioned what has otherwise been a stark erosion in debt servicing capabilities: there is little scope for a parallel upshift in the global interest rate structure. These are bullish conditions for gold shares, as captured by the upbeat reading in our Cyclical Gold Indicator (Chart 9, top panel). As such, when we took profits we advised that we would look to return to an overweight position once tactical downside risks had been reduced. Are we there yet? Chart 10 suggests that extreme bullishness toward the yellow metal has not yet fully unwound. While the share price ratio has dropped back to its 200-day moving average, cyclical momentum remains elevated, as measured by the 52-week rate of change. Sentiment in the commodity pits is still elevated, flows into gold ETFs are still strong and net speculative positions have not yet made a full retreat (Chart 10), especially in view of the recent politically-motivated pop in market volatility. The implication is that there could be additional selling pressure in the coming weeks. Chart 9Cyclically Appealing, But... Chart 10... Still Tactically Frothy Chart 11The Currency Is Critical In terms of potential buy triggers, anything that causes the U.S. dollar to lose its bid is a strong candidate. Ironically, a Fed rate hike could produce such an outcome, contrary to popular wisdom. In our view, the U.S. (and global) economy cannot handle tighter financial conditions, and a rise in interest rates would need to be offset by a weaker currency. Gold shares perform well when economic expectations are faltering (Chart 11, shown inverted), and a hawkish Fed would likely raise global economic fears. On the flipside, a go-slow Fed could keep the currency bid. That would allow the economy more time to heal and recover, and possibly overheat, thereby potentially boosting future returns on capital, certainly relative to other countries where output gaps remain larger. Bottom Line: Stay neutral on gold stocks, but put them on upgrade alert in recognition that an upgrade back to overweight could occur sooner rather than later, i.e. by yearend, depending on macro dynamics. What To Do With Drug Stocks? A number of drug wholesalers reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has not been confirmed by neither strong retail drug store sales nor booming hospital employment (Chart 12). Nor is there an unwanted inventory build (Chart 12). Nevertheless, in light of new information, which implies that company-reported pricing pressure is worse than current government data shows, we are downgrading our outlook for drug-related shares. Still, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels (Chart 12), we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. Keep in mind that the drug price increases are still well in excess of the overall rate of inflation as branded drug prices continue to rise (Chart 13), and earnings stability should be increasingly desirable as the U.S. dollar climbs. In the meantime, drug-related shares are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit if drug inflation cools. For instance, a reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent (Chart 14), underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Chart 12Under The Gun... Chart 13... But Pricing Power Remains Strong Chart 14Celebrating Reduced Cost Inflation Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions (Chart 14), suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: The pain in drug-related shares should provide a gain to health care insurers. Stay overweight the S&P managed care index. However, look to lighten the S&P pharmaceutical and biotech indexes on a relative performance bounce in the coming weeks, both are now on downgrade alert. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components Chart 5Protector Portfolio Returns In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady Chart 9Wage Growth Is Perking Up To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html
Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar Chart I-5Lower Impact Of Manufacturing ##br##And Commodities Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion Chart I-9China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Dear Client, In addition to this week's regular Weekly Report, you should have also received a Client Note written by my colleague Marko Papic discussing the upcoming U.S. presidential election. Marko argues that the election is now too close to call. Donald Trump's resilience in the polls continues to baffle most observers. Not us. Back in September of 2015, when most pundits were laughing off Trump's chances, we wrote a report arguing that Trump's rhetoric would resonate with voters much more than most people thought possible. That report, entitled "Trumponomics: What Investors Need To Know," is as relevant today as it was back then. Best regards, Peter Berezin Highlights Spare capacity has narrowed substantially within the developed world. Most of the decline in spare capacity is attributable to lackluster supply, rather than stronger demand. Potential GDP growth is likely to remain weak over the coming years. Narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. At least in this respect, central bankers may find themselves with a few more bullets in their arsenals. Stay long the dollar and position for gradually higher government bond yields. Global equities are highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. Feature Spare Capacity Is Dwindling A persistent shortfall of aggregate demand has been the defining feature of the global economic landscape ever since the financial crisis erupted. This chronic lack of spending has kept inflation below target in most developed economies, forcing central banks to adopt ever more radical easing policies. That is starting to change. Spare capacity continues to decline, allowing once dormant supply-side constraints to reimpose themselves. In this week's report, we take stock of where we are in this process. Mind The (Output) Gap The simplest measure of spare capacity is the so-called output gap, which estimates the difference between what economies are actually producing and what they are capable of producing without putting undue upward pressure on inflation. According to the IMF, the output gap for advanced economies has narrowed from a high of 3.8% of GDP in 2009 to 0.8% at present. The OECD's measure shows a similar decline (Chart 1). Chart 1AOutput Gaps Have Narrowed Chart 1BOutput Gaps Have Narrowed The IMF reckons that the output gap has nearly closed in the U.S. and the U.K. The Fund estimates that Japan's output gap currently stands at 1.5% of GDP. The OECD also sees the U.K. output gap as being fully closed. However, it calculates a smaller output gap for Japan but a larger output gap for the U.S. than the IMF does. Both institutions peg the euro area's output gap at around 1%-to- 1.5%. Not surprisingly, there is a fair bit of variation within continental Europe. The output gap in Germany has fully disappeared, but still stands at 2%-to-3% of GDP in Italy and Spain. Naturally, one should take these numbers with a grain of salt. Output gaps are notoriously difficult to calculate and are subject to large revisions. The OECD, for example, tends to rely on statistical approaches to estimate output gaps.1 These typically involve employing tools such as the so-called "Hodrick-Prescott filter" to smooth out historical GDP data and then treating the resulting trendline as an estimate for potential GDP. Such methods have their uses, but they can go badly awry in situations where GDP is slow to return to its "true" underlying trend. This is a particular worry in the current environment, considering that recoveries following burst asset bubbles tend to be lethargic even in the best of times. The fact that fiscal policy has been fairly tight and monetary policy has been constrained by the zero lower bound has further dampened the recovery. With that in mind, rather than relying on purely statistical techniques, it is useful to measure spare capacity directly. We do this by gauging the extent to which the existing factors of production - labor and capital - are being effectively deployed across the major developed economies. As we argue below, this approach suggests that slack may be modestly higher in Japan than what the IMF and the OECD calculate, and more meaningfully understated in peripheral Europe. The Message From Headline Unemployment Rates Unemployment has been falling in almost all major developed economies (Chart 2). In the U.S. and the U.K., the jobless rate is back to pre-crisis levels. In Germany and Japan, it is below where it was before the Great Recession. As such, it is unlikely that unemployment can decline much in these economies. Chart 2AUnemployment Rates Have Declined Chart 2BUnemployment Rates Have Declined In contrast, while unemployment rates in peripheral Europe have been trending lower over the past three years, they are still quite high by historical standards. There is some debate over whether they can fall much further. The OECD, for example, contends that Spain is already close to full employment, even though the country's unemployment rate still stands at nearly 20%. We find this implausible. The OECD essentially takes a moving average to calculate structural unemployment rates in various economies. As noted above, this can be highly misleading in circumstances where the forces pushing an economy towards full employment are impaired. In general, this suggests that both the IMF and the OECD estimates of labor market slack in the euro area are too low. This is consistent with a recent ECB research paper, which calculated that the euro area's output gap was 6% of GDP in 2015, a far cry from the European Commission's estimate of 1.1%.2 Disguised Unemployment The unemployment rate is probably the single best measure of labor market slack. However, it can understate the true amount of spare capacity during periods when many people have stopped looking for work, or when those who are employed are not working as much or as intensively as they would like. The nature of this additional labor market slack differs from region to region. In the U.S., it has mainly manifested itself in lower labor force participation rates; whereas in Europe - perhaps in keeping with the more egalitarian nature of European society - it has mainly taken the form of fewer hours worked and a higher incidence of involuntary part-time employment. Chart 3 shows that labor force participation rates among prime-age workers (those between the ages of 25-and-54) in Europe are generally higher now than they were before the financial crisis. In contrast, the share of workers who have part-time jobs but desire full-time employment remains elevated across most of continental Europe (Chart 4). The average annual number of hours worked per employee has also declined in most European economies (Chart 5). Chart 3ALabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 3BLabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 4AEurope: Higher Incidence Of ##br##Involuntary Part-Time Employment Chart 4BEurope: Higher Incidence ##br##Of Involuntary Part-Time Employment In the U.S., the prime-age labor force participation rate is still 1.9 points lower than it was in 2007. Part of this is cyclical. As long as the labor market continues to improve, participation rates among prime-age workers should continue to recover. That's the good news. The bad news is that ongoing structural forces are likely to prevent the participation rate from returning back to its pre-crisis levels. Chart 6 shows that labor force participation rates among U.S. prime-aged males has been trending lower since the 1960s. The decline has been particularly acute among less-educated workers. Why this has happened remains a source of intense debate. Conservative commentators have argued that cultural shifts have reduced the social pressure on men to maintain gainful employment. Liberal commentators have contended that falling real wages at the lower end of the skill distribution have reduced the incentive to work. Whatever the reason, it will be difficult to boost labor participation substantially from current levels. At present, 11% of U.S. prime-aged nonparticipants report wanting a job, only modestly higher than before the recession (Chart 7). It is possible that some fraction of those who do not want to work will change their minds - indeed, this year has seen a modest inflow of "disabled" people back into the labor force. Realistically, however, this is unlikely to boost labor participation by more than one percentage point. Chart 5Hours Worked ##br##In Europe Have Declined Chart 6U.S.: The Less Educated ##br##Are Shunning The Labor Force Chart 7U.S.: Fewer Potential Workers ##br##On The Sidelines Chart 8Japan's Underutilized Labor Force The incidence of involuntary part-time employment in Japan has returned to where it was prior to the Great Recession. However, in absolute terms, it remains quite high - in fact, nearly as high as in Europe. Japanese full-time employees may also not be as productively engaged as they could be. As evidence, note that output-per-hour in Japan is 37% lower than in the U.S. and 33% lower than in Germany (Chart 8). From this we conclude that there is somewhat more labor market slack in Japan than the headline unemployment rate suggests. Industrial Capacity Utilization Goods-producing sectors typically account for less than a third of GDP in most advanced economies. Nevertheless, because the demand for goods tends to be more volatile than the demand for services, fluctuations in industrial production often account for the bulk of the changes in output gaps. As Chart 9 shows, after a brisk recovery following the financial crisis, the U.S. industrial capacity utilization rate has been trending lower for the past two years. It currently stands at 75.4%, 5.6 percentage points lower than at its pre-recession peak. The Institute for Supply Management's semi-annual capacity utilization survey also suggests that many U.S. manufacturing businesses are operating substantially below potential (Chart 10). Much of the deterioration in U.S. industrial utilization reflects the effects of the energy bust and a stronger dollar. Business capex has decelerated sharply as a consequence of these forces, falling by over two-thirds in the case of energy capex. This should cut into excess capacity. Chart 9U.S.: Industrial Capacity ##br##Utilization Remains Low Chart 10U.S.: Less Slack In Services ##br##Than Manufacturing The dearth of new investment elsewhere in the world should also help prop up utilization rates (Chart 11). Industrial utilization is close to its historic average in Europe. Unlike in the case of labor markets, there is not a lot of regional variation in capacity utilization rates across the euro area. If anything, Italian spare capacity is actually closer to its pre-recession level than Germany's. Chart 11AEurope: Idle Industrial Capacity Is Shrinking Chart 11BEurope: Idle Industrial Capacity Is Shrinking Chart 12Excess Capacity Has Declined In Japan Capacity utilization has also returned to its long-term trend in Japan. Encouragingly, the Tankan Factor Utilization Index has risen to its highest level since the early 1990s (Chart 12). Nevertheless, the strong yen is starting to put pressure on Japan's industrial sector. This suggests that further monetary easing from the BoJ will be necessary. Economic And Investment Implications Our analysis suggests that spare capacity has narrowed substantially within the developed world, although for some countries not quite as much as output gap estimates from the IMF and the OECD indicate (particularly in the case of peripheral Europe). Unfortunately, most of the decline in spare capacity is attributable to lackluster supply, rather than faster demand growth (Chart 13). Interestingly, a cyclically-induced withdrawal of workers from the labor market has only played a modest role in explaining the slowdown in potential GDP growth and the resulting decline in output gaps. Instead, most of the deceleration in potential GDP growth stems from lower productivity gains. Chart 13AWeak Supply Growth Has Narrowed Output Gaps Chart 13BWeak Supply Growth Has Narrowed Output Gaps Some of the decline in productivity growth reflects cyclical factors, especially weak business investment. However, as we have discussed in past reports, much of it reflects structural forces such as declining educational achievement and a shift in focus of internet innovation away from business productivity applications towards consumer services such as social media.3 Looking out, narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection via the CPI swap market. Governor Kuroda has made it clear that he wants Japanese inflation to rise above 2% to make up for the fact that inflation has perpetually undershot the BoJ's target. The Bundesbank may not want higher inflation, but the ECB's need to reflate Southern Europe all but guarantees such an outcome. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. The essence of forward guidance is the commitment to keeping monetary policy ultra loose even when the economy begins to overheat. If people believe that the central bank will keep the punch bowl filled, this could cause long-term inflation expectations to rise, leading to lower real yields and increased spending today. Such a commitment is likely to be regarded as more credible if people expect it to be carried out over the next few years, rather than at some distant point in the future. The Bank of Japan has already moved in that direction with its pledge to engineer an inflation overshoot by keeping the 10-year JGB yield anchored at zero. Chart 14China: On The Mend, Cyclically The U.S. has the smallest output gap, but the highest neutral interest rate, among the major developed economies. This week's FOMC statement strongly hinted at a December rate hike. As we discussed two weeks ago, in addition to one hike this year, we expect the FOMC to hike rates twice next year.4 This should cause the real broad trade-weighted dollar to appreciate by 10% over the next 12 months. A stronger dollar will mitigate some of the upward pressure on U.S. bond yields. Nevertheless, as slack continues to erode and inflation shifts higher, Treasury yields, along with bond yields elsewhere, should continue trending higher. Global equities are currently highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. We are currently short the NASDAQ 100 futures as a hedge, a trade that has gained 3.1% since we initiated it. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. This is partly because U.S. stocks are relatively expensive, but it is also because an ascending dollar will hurt U.S. multinationals. Investors should overweight Japanese and European stocks on a currency-hedged basis within the developed market universe. The outlook for emerging markets is mixed. On the one hand, the recent uptick in Chinese growth - as evidenced by this week's better-than-expected PMI data (Chart 14) - should provide some support to commodity prices and EM assets. On the other hand, a stronger dollar will weigh on commodities, while making it more onerous for some emerging market companies to refinance their dollar-denominated loans. Higher U.S. rates could also reduce the global pool of dollar liquidity, making it difficult for some emerging markets to finance their current account deficits. On balance, a modestly underweight stance towards EM assets is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 The IMF uses a more ad hoc approach. Desk economists have significant leeway in how they estimate output gaps for their respective economies. Most economists rely on statistical models and production function calculations, intermixed with educated guesswork. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015; and Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades