Geopolitics
Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.
Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Chart 10Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.
Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.