Gov Sovereigns/Treasurys
Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up... The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments. Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019 II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices. “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-8Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-10The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector. This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat? Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity. Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22). Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2 Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4 Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5 A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6 G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7 The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8 J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9 J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10 M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11 O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12 J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13 J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14 “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15 Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16 Productivity can be written as: 17 J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:
Highlights When it comes to policy easing, the euro area 5-year yield at -0.15 percent is running out of road, while the U.S. 5-year yield is still at the dizzying heights of 1.8 percent. Hence, the ECB is likely to come out the loser in any ‘battle of the doves’ with the Federal Reserve. German bunds will continue to underperform U.S. T-bonds Take profits in the overweighting to Spanish Bonos and Portuguese bonds. Equity investors should go underweight European industrials and switch to the less economically-sensitive and price-sensitive healthcare sector. Feature The German 5-year bund yield recently plunged to -0.7 percent – significantly below even the -0.25 percent yield on the Japanese 5-year government bond (JGB) (Chart of the Week). This has left many people scratching their heads and wondering: is the bond market signalling that Europe is on the cusp of a vicious deflationary vortex? Chart I-1Bund Yield, How Low Can You Go? The answer is, not necessarily. The head-to-head comparison of the yields on German bunds and JGBs is misleading, because the German bund yield includes a significant discount for the possibility of currency redenomination to a new ‘super deutschmark’ (Chart I-2) while the JGB yield does not, and cannot, have such a redenomination discount given that the yen cannot break up. Chart I-2The German 5-Year Bund Yield Carries A Redenomination Discount Why The German Bund Yield Can Go Deeply Negative The German bund yield can drop to deeply negative levels, even when the policy interest rate is, and expected to remain, close to zero. This is because a negative yield on the German bund is rational if investors anticipate an equal and opposite currency gain in the event that the euro broke up. A negative yield on the German bund is rational if investors anticipate an equal and opposite currency gain. For example, if you were certain that the bund was going to deliver you deutschmarks worth 20 percent more than euros, you would accept a symmetrically negative yield near -20 percent; if you were sure of a 10 percent redenomination gain, you would accept a yield near -10 percent; and even if you expected a relatively low one-in-twenty likelihood of the 10 percent redenomination gain, this would equate to an expected gain of 0.5 percent, so you would accept a negative yield near -0.5 percent.1 Hence, an individual euro area bond yield is made up of three components: The interest rate term-structure. The likely size and direction of a currency redenomination. The likelihood of such a currency redenomination event. Chart I-3The Euro Area Term-Structure Is Much Lower Than In The U.S., But Not Quite As Low As In Japan By contrast, the yield on the JGB, U.S. T-bond and U.K. gilt is made up of just the first component, the interest rate term-structure. So, unlike the JGB, T-bond, or gilt, we cannot get information about the euro area’s interest rate term-structure from the German bund yield – or any other euro area bond yield – by itself. Fortunately, we can derive the euro area interest rate term-structure from the average euro area bond yield because, at the aggregate level, the expected currency redenomination must sum to zero.2 Understanding the components of the German 5-year bund yield enables us to decompose its current -0.7 percent yield into two parts: -0.15 percent is from the interest rate term-structure – which is low but not quite as low as Japan (Chart I-3) – while the lion’s share, -0.55 percent, is from the redenomination discount. A Strategy For Bonds Turning to the decline in the yield through the past nine months, the lion’s share has not come from a widening redenomination discount. It has come from a collapse in the global interest rate term-structure, during which the redenomination discount has actually narrowed by 0.2 percent. One important consequence is that German bunds have underperformed their peers as their yield shortfall versus both U.S. T-bonds and Italian BTPs has narrowed (Chart I-4 and Chart I-5). Can the trend continue? Chart I-4The German 5-Year Bund's Yield Shortfall Has Narrowed Versus Both U.S. T-Bonds And Italian BTPs Chart I-5The German 10-Year Bund's Yield Shortfall Has Narrowed Versus Both U.S. T-Bonds And Italian BTPs The answer is yes. When it comes to policy easing, the euro area 5-year yield at -0.15 percent is running out of road, compared with the U.S. 5-year yield at the dizzying heights of 1.8 percent. Put bluntly, from these levels of yields the ECB is likely to come out the loser in any ‘battle of the doves’ with the Federal Reserve and bunds will underperform T-bonds – exactly as we witnessed last week. Meanwhile, as absolute yields have declined euro redenomination (break-up) risk has actually diminished (Chart I-6). This makes perfect sense because solvency is an absolute concept, and the solvency of fragile Italian banks has improved in line with the higher capital values of their Italian BTP holdings. Many euro area ‘periphery’ yield spreads have already compressed to wafer-thin levels. That said, many euro area ‘periphery’ yield spreads have already compressed to wafer-thin levels. Hence, we are pleased to report that our overweighting to Spanish Bonos (versus French OATS) is now up 10 percent while our long-standing overweighting to Portuguese bonds is up 50 percent. Given that most of the yield spread compression for Spain and Portugal is now over, we are closing these positions and taking the healthy profits (Chart I-7). Chart I-6Euro Break-Up Risk Has Diminished Recently Chart I-7For Spain, Most Of The Yield Spread Compression Has Already Happened Where President Trump Is Right About Europe President Trump and the ECB might be like chalk and cheese, but they do agree on one thing. The ECB’s own analysis – available at https://www.ecb.europa.eu/stats – shows that the trade-weighted euro needs to appreciate by at least 10 percent to cancel the euro area’s competitive advantage versus its major trading partners including the United States (Chart I-8). Chart I-8The Euro Needs To Appreciate By 10 Percent To Cancel The Euro Area’s ##br##Over-Competitiveness Even more controversially, the central bank’s own analysis shows that the ECB itself is to blame for the euro area’s significant competitive advantage. Prior to the ECB’s extreme and unprecedented policy easing, the euro area’s competitiveness was exactly in line with its trading partners. The ECB does not explicitly target the exchange rate, but it is fully aware that extremely accommodative monetary policy, and especially relative monetary policy, will boost the euro area’s competitiveness and thereby create trade imbalances. On this point, President Trump is spot on (Chart I-9). Chart I-9Relative Monetary Policy Has Created The Huge Trade Imbalance Between The Euro Area And The U.S. Even if the ECB feels justified in its policy, it is now running out of road. To reiterate, in the coming months the ECB is likely to come out second best in any ‘battle of the doves’ with the Federal Reserve. Any resulting yield spread compression between the euro area and U.S. will lift the euro and start to correct the euro area’s massive trade surplus with the U.S. The euro needs to appreciate by 10 percent to cancel the euro area’s competitive advantage. Another development is that the up-oscillation in growth that has benefited the euro area, and world, economy over the past two or three quarters is about to end and flip into a down-oscillation. We will expand on this crucial issue in next week’s report, so don’t miss it! Putting this all together, euro area firms exporting price-elastic discretionary goods and services are likely to get hurt. For the second half of the year, equity investors should go underweight European industrials and switch to the less economically-sensitive and price-sensitive healthcare sector. Finally, following the dovish surprises from central banks in recent weeks, our short 30:60:10 portfolio of equities, bonds and oil reached its 3 percent technical stop-loss. However, we are maintaining the short portfolio for the time being, in the belief that a continued synchronized rally across all asset-classes is now harder to deliver. Fractal Trading System* Supporting the fundamental argument in the main body of the report, the fractal trading system highlights that the 6-month outperformance of euro area industrials is now technically extended and vulnerable to a trend-reversal. Accordingly, this week’s recommended trade is to short euro area industrials versus the market. The tickers are EXH4 versus EXSA, and the profit target is 2 percent with a symmetrical stop-loss. In other trades, short bitcoin reached its stop-loss and is now closed. The other trades are all in profit. 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-10Euro Area Industrials Vs. Market 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. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The numbers quoted are for a simplified example. Consider a zero-coupon German bund redeeming at 100 a year from now. If the interest rate was zero, then you would pay 100 for it today, meaning the bund yield would be zero. But if you were certain that the bund would redeem not in euros, but in deutschmarks which would appreciate 20 percent versus the euro, you would pay 120 for the bund, meaning it would yield -17 percent. If the certain redenomination was a 10 percent appreciation, you would pay 110, and the yield would be -9 percent. But if this 10 percent redenomination was uncertain with a probability of 5 percent, your expected gain would be 0.5, you would pay 100.5, and the yield would be -0.5 percent. 2 Effectively, we can think of the euro as the sum of its strong and weak ‘component’ currencies. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Fed: The Fed will cut rates in July, and possibly once more this year. This extra stimulus will help boost global growth in the second half of 2019. Credit: With inflation expectations low, the Fed will not risk upsetting financial markets by striking a hawkish tone. This will be a boon for corporate bonds. We no longer advocate a cautious near-term allocation to corporate credit. Spreads have likely peaked. Duration: The economic environment bears a greater resemblance to prior mid-cycle slowdowns than to prior pre-recession periods. As such, the Fed will not deliver more than the 89 basis points of rate cuts that are already discounted for the next 12 months. Maintain below-benchmark portfolio duration. Feature More Houdini Than Bullwinkle When Fed Chair Jay Powell reached into his hat at last week’s FOMC meeting, most – including us – thought he might emerge looking like Bullwinkle the cartoon moose.1 Instead, he pulled a rabbit, delivering a dovish surprise to markets that already expected a lot. The yield curve was discounting 80 basis points of rate cuts over the next 12 months heading into last Wednesday’s announcement. Then, the Fed’s statement and Powell’s press conference pushed our 12-month discounter all the way down to -94 bps (Chart 1). The 10-year Treasury yield also dropped 8 bps post-FOMC, while the 2-year yield fell a whopping 14 bps. The Fed will go to great lengths to signal that monetary conditions remain accommodative. The Fed communicated its dovish pivot through both the post-meeting statement and its interest rate projections. In the post-meeting statement, the Fed replaced its pledge to be “patient” with a promise to “act as appropriate to sustain the expansion”. A re-phrasing that is clearly designed to signal a rate cut in July. FOMC participants also revised their interest rate projections sharply lower (Chart 2). In March, 11 out of 17 participants expected the Fed to stay on hold for the balance of 2019, while 4 participants called for one rate hike and 2 called for two rate hikes. Now, 8 out of 17 participants continue to expect a steady fed funds rate, but 7 are calling for two rate cuts this year. Only one participant is still looking for a 2019 hike. Chart 1A Dovish Magic Show Chart 2Dots Revised Lower In his press conference, Chair Powell explicitly linked the Fed’s dovish pivot to “trade developments” and “concerns about global growth”. Bond investors will undoubtedly heed this message, and Treasury yields will be extra sensitive to any trade-related news that comes out of this weekend’s G20 summit, as well as to any fluctuations in the global growth data (see section titled “No PMI Recovery Yet” below). Ultimately, our baseline expectation is that there will be enough progress in trade negotiations at the G20 summit to keep the U.S. from imposing a further $300 billion in tariffs on Chinese imports. However, an all-encompassing deal, which rolls back existing tariffs, is not in the cards. Table 1Fed Funds Futures: What's Priced In? But even such a muddle-though scenario, when combined with a Fed rate cut in July and continued credit easing out of China, will be sufficient to support global growth in the second half of this year. This will prevent the Fed from delivering the 79 bps of rate cuts that are priced-in for between now and next February (Table 1). We remain short the February 2020 fed funds futures contract. And Now Here’s Something We Hope You’ll Really Like Our main takeaway from the FOMC meeting is that the Fed will go to great lengths to signal that monetary conditions remain accommodative. We posited back in March that the new battleground for monetary policy is between inflation expectations and financial conditions.2 That is, the Fed will only move to a restrictive policy stance in response to above-target inflation expectations or “bubbly” financial asset prices. While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. At present, long-maturity TIPS breakeven inflation rates remain well below target levels and financial markets are far from “bubbly” (Chart 3): The Financial Conditions component of our Fed Monitor is close to neutral (Chart 3, panel 2). The S&P 500 12-month forward P/E ratio has rebounded this year, but is not close to the highs seen in late-2017/early-2018 (Chart 3, panel 3). The GZ measure of the excess premium in corporate bond spreads after accounting for expected default losses is low, but above where it traded throughout most of the 2000s (Chart 3, bottom panel). The upshot is that the Fed will continue to act as a tailwind for risk assets, and we therefore remove our prior recommendation to stay cautious on credit spreads in the near-term. It is now likely that credit spreads have peaked, a message confirmed by our list of “peak credit spread” indicators (Chart 4): Chart 3No Rush For Fed To Tighten Chart 4Credit Spreads Have Likely Peaked The price of gold has decisively broken-out to the upside, a sign that the market views monetary policy as reflationary (Chart 4, panel 2). Such a breakout has preceded the last two peaks in corporate bond spreads. The dollar’s uptrend has abated, signaling that the market views U.S. monetary policy as less out of step with the rest of the world (Chart 4, panel 3). Global industrial mining stocks have rebounded (Chart 4, panel 4). The CRB Raw Industrials index is the sole holdout (Chart 4, bottom panel). A rebound in this index would confirm our intuition that credit spreads have peaked. Chart 5Waiting For Improving Global Growth While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. The ratio between the CRB Raw Industrials index and Gold correlates very tightly with the 10-year yield, and it continues to plummet (Chart 5). The CRB/Gold ratio will only rise when gains in the CRB index start to outpace gains in Gold. In other words, the Fed’s reflationary policy stance needs to translate into an improving global growth outlook. This could take a few months, though we ultimately continue to think that Treasury yields will be higher on a 6-12 month horizon. As explained in the next section, as long as the U.S. economy avoids recession, mid-cycle rate cuts tend to be followed by higher Treasury yields. A History Of Rate Cuts Part 2 In last week’s report we looked at every Fed rate cut since 1995 and showed how the 10-year Treasury yield reacted during the subsequent 21-day, 65-day, 130-day and 261-day periods.3 Our main conclusion was that the 10-year Treasury yield tended to rise following mid-cycle rate cuts, such as those that occurred in 1995-98 and 2003, and decline following rate cuts that led into a U.S. recession. For reference, we have attached last week’s analysis as an Appendix to this report, along with a new table showing how the Bloomberg Barclays Treasury Master index performed relative to cash following each post-1995 rate cut. The 2/10 Treasury slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. This week, we delve a little deeper and look at the market’s interest rate expectations around each prior cut, and also at how the 2/10 Treasury slope responded in each case. Rate Expectations At The Time Of Fed Rate Cuts Table 2 shows the 12-month change in the fed funds rate that the market was discounting prior to each Fed rate cut announcement since 1995. It also shows the actual change in the fed funds rate that occurred over the subsequent 12-month period, and the difference between what occurred and what was expected – the 12-month fed funds surprise. Table 2A History Of Rate Cuts: Rate Expectations According to our Golden Rule of Bond Investing, a dovish surprise (actual change < expectations) should coincide with a falling 10-year Treasury yield, and a hawkish surprise (actual change > expectations) should coincide with a rising 10-year yield.4 The table shows that this indeed occurred in 26 out of 29 episodes. As was the case last week, the mid-1990s rate cuts immediately capture our attention. We have previously noted the resemblance between today’s economic environment and that of the mid-1990s.5 It’s interesting that the market is currently priced for a similar number of rate cuts as at that time. Once again, we expect those expectations will be disappointed. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield. Yield Curve: Steeper Now = Flatter Later Another interesting trend is that the 2/10 Treasury slope steepened dramatically in the run-up to, and following, last week’s FOMC meeting. It is now back up to 29 bps after having troughed at 11 bps near the end of last year (Chart 6). It is also worth noting that the 2/10 Treasury slope has yet to invert this cycle. Such an inversion has occurred prior to every U.S. recession since at least 1960. Table 3 shows how the 2/10 Treasury slope has responded to Fed rate cuts in the past, and it reveals an interesting pattern. The slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. The 2003 episode is a prime example. The 2/10 slope steepened by 62 bps in the month following the rate cut, but a year later it was 14 bps below where it started. Chart 6The Fed Steepens The Curve Table 3A History Of Rate Cuts: 2/10 Treasury Slope In contrast, the 2/10 steepening that immediately follows a “pre-recession” rate cut tends to be milder, but the steepening then accelerates as time passes and the Fed eases further. The observed yield curve patterns line up well with theory. We would expect rapid curve steepening immediately following a mid-cycle rate cut, as the market prices in a quick return to tighter policy settings. Then, the curve should eventually flatten as the Fed reverses its initial cuts. In contrast, a rate cut that precedes a recession should not lead to much initial steepening, because the market would not be expecting a quick recovery. The steepening would then accelerate as more rate cuts are eventually delivered. The fact that the 2/10 slope has steepened a lot in recent weeks is another datapoint in favor of “mid-cycle” rather than “pre-recession” market behavior. No PMI Recovery Yet We remain confident that the combination of a July Fed rate cut and Chinese credit stimulus will put a floor under global growth in the second half of the year. However, no such global growth rebound is yet evident in the crucial manufacturing PMI data. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield, and it remains in a free-fall, even breaking below the 50 boom/bust line in May (Chart 7). Flash PMI data paint an equally dim picture for June: The Euro Area Manufacturing PMI is expected to tick up in June, but only to 47.8 from 47.7 in May (Chart 7, panel 2). The U.S. Manufacturing PMI is expected to fall to 50.1 in June, from 50.5 in May (Chart 7, panel 3). The Japanese Manufacturing PMI is expected to fall to 49.5 in June, from 49.8 in May (Chart 7, bottom panel). There is no Flash PMI data for China, but the Chinese index stood at 50.2 in May, only a hair above the 50 boom/bust line. On the bright side, financial markets are starting to price-in the beginnings of a reflation trade. Gold is rallying strongly, as we noted above, and an index of high-beta currency pairs (RUB/USD, ZAR/USD and BRL/USD) is off its lows. Both of these moves signal that the policy backdrop is becoming more supportive, and both have led upswings in the Global Manufacturing PMI in the past (Chart 8). Chart 7No Rebound In Sight Yet... Chart 8...But Financial Markets Are Already Looking Ahead Bottom Line: Treasury yields will probably need to see a rebound in the Global Manufacturing PMI before moving higher, but a few reflationary indicators suggest that such a rebound will occur in the second half of the year. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Appendix Table 4A History Of Rate Cuts: 10-Year Treasury Yield Table 5A History Of Rate Cuts: Treasury Excess Returns Footnotes 1 https://www.youtube.com/watch?v=kx3sOqW5zj4 2 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Interest rate differentials are moving against the dollar, but our important takeaway – that gold continues to outperform Treasurys – is an ominous sign. Gold has stood as a viable threat to dollar liabilities, any sign that the balance of forces are moving…
Highlights As long as the global long bond yield stays near 2 percent or below, European equities will end the year at broadly the same level as now… …but they will experience a dip of at least 4-5 percent along the way. All central banks have pivoted to dovish but the Fed has more easing armoury than the ECB. This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. Feature At the start of this year we explained Why 2019 Is A Pivotal Year For Monetary Policy. Today we want to elaborate on that report, and its key observations: Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to tightening emanates from the hyper-sensitivity of financial conditions to rate hikes, rather than from the direct impact on rate-sensitive sectors in the economy. Since October 2017, no stock market rally or sell-off has lasted more than three months or so (Chart Of The Week). These observations are as relevant – or more relevant – now, as they were at the time of our original report.1 Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent. Chart Of The WeekSince October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months A 2 Percent Tightening Is The Post-2008 Limit Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before having to reverse course (Chart I-2 and Chart I-3). Chart I-2A 2 Percent Sequential Tightening Is The Post-2008 Limit Chart I-3A 2 Percent Sequential Tightening Is The Post-2008 Limit In 2008, Swedish interest rates peaked near 5 percent before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Though admittedly, both Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. However, on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening also of only 1 percent; Korea could manage just 1.25 percent; the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. The Federal Reserve raised interest rates sequentially by 2 percent through December 2016 to December 2018, and guess what – it is now on the cusp of reversing course. The ultimate course will have a huge bearing on investment strategy for European equities, bonds and currencies. The Neutral Real Rate Of Interest Is Zero Many economists and strategists expected the Fed to continue hiking through 2019, but this publication pushed back hard. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. Central to this publication’s resistance was, and is, a high-conviction view that the so-called ‘neutral’ real rate of interest – the real interest rate that is neither accommodative nor restrictive, the real interest rate consistent with an economy maintaining full employment while keeping inflation constant – is zero. The neutral rate of interest is very low. In our Special Report Why The Neutral Rate Of Interest Is Zero we proposed that the neutral rate is global rather than region-specific, that it refers to the bond yield rather than to the policy rate, and that it is extremely low. As it happens, the Fed broadly concurs. With the policy rate, bond yield, and inflation all at around 2 percent, the real policy rate and real bond yield are both near zero. At this level the central bank claims that “the policy stance is now in the Committee’s estimates of neutral… and when you get to that range we have to let the data speak to us.”2 However, the data that is speaking most loudly is not necessarily the economic data, it is the financial market data. Jay Powell has said that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” We think it has (Chart I-4). Comparing Today’s Rich Valuations With 2007 In the aftermath of the dot com bubble burst in 2000, policy interest rates collapsed to very low levels but, crucially, long bond yields did not. This contrasts with the aftermath of the Global Financial Crisis in 2008, during which both policy interest rates and bond yields have plunged to all-time lows (Charts I-5 - I-7). Funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. Chart I-5In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did Chart I-6In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did Chart I-7In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did The difference between the post-2000 and post-2008 policy responses can be summarized in two letters: QE. For all its apparent complexity, QE is actually a very simple monetary policy tool. It is just a mechanism for signalling that the policy interest rate will remain low for an extended period. Thereby, QE pulls down the long-term interest rate, which is to say the long bond yield. The double-digit rally over the past six months is technically extended. But as we have consistently pointed out on these pages, funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. We refer readers to our other reports for the details, but in a nutshell the risk of owning bonds converges to the risk of owning equities and other so-called ‘risk-assets’. The upshot of this risk convergence is that investors price these risk-assets to deliver the same ultra-low nominal return as bonds, meaning that the valuation of the risk-assets soars.3 Chart I-8Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent All of which brings us to the crucial point. The post-2000 extreme policy easing distorted the real economy. It engineered a credit boom. So the fragility to the subsequent policy tightening emanated from the real economy, and particularly the most rate-sensitive sectors in the economy such as mortgage lending and housing. In contrast, the post-2008 extreme policy easing – driven by QE – has distorted the valuation of risk-assets. Moreover, the value of global risk-assets, at $400 trillion dwarfs the $80 trillion global economy by five to one. So the current fragility to policy tightening does not emanate from the real economy, it emanates from the hyper-sensitivity of financial conditions to higher bond yields (Chart 8). Some European Investment Implications The integration of global capital markets means that the valuation anchor for European – and all regional – stock markets now comes from the global long bond yield, which we define as the simple average of the 10-year yields in the euro area, U.S., and China. Through the past five years, the inability of the global long bond yield to remain above 2.5 percent confirms the hyper-sensitivity of financial conditions to higher interest rates. And it suggests that the ‘neutral’ rate on this measure is around 2 percent. The good news is that this measure now stands slightly below neutral at 1.9 percent. The euro has a sound structural underpinning versus the dollar. At around this level of the global long bond yield, the rich valuation of European equities has some support. That said, the double-digit rally over the past six months is technically extended, as most of the things that could go right did go right – central banks pivoted to dovish, euro area growth rebounded, and, until recently, geopolitical risks were easing. Hence, as long as the global long bond yield stays near 2 percent or below, we expect European equities to end the year at broadly the same level as now, though our technical signals do strongly suggest a dip of at least 4-5 percent along the way (Chart I-9). Chart I-9The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended Chart I-10The Fed Has More Easing Armoury Than The ECB As regards bonds and currencies, all central banks have pivoted to dovish but the Fed has more easing armoury than the ECB (Chart I-10). This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. However, this structural underpinning also applies to the yen, and until we get some clarity on Brexit we prefer the yen over the euro. Fractal Trading System* In line with the main body of this report and Chart 9, we see evidence that the double-digit rally in stock markets over the past six months is technically extended. Accordingly, this week’s recommended trade is to short the MSCI All-Country World index, setting the profit target at 4 percent with a symmetrical stop-loss. This leaves us with four open positions. 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. * 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. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report ‘Why 2019 Is A Pivotal Year For Monetary Policy’ February 7, 2019 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Special Report ‘Why The Neutral Rate Of Interest Is Zero’ June 6, 2019 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Fed: Depressed U.S. Treasury yields now discount more rate cuts than the FOMC is likely to deliver, even for “insurance” purposes to offset the negative growth impacts from trade policy uncertainty. Maintain a below-benchmark strategic U.S. duration stance, and stay underweight the U.S. in global hedged government bond portfolios. JGBs: The low yield beta of Japanese government bonds can be a useful diversifier of duration risk in global government bond portfolios. We recommend taking advantage of this by increasing allocations to Japan, out of U.S. Treasuries, on a currency-hedged basis (in USD). Feature June FOMC Preview: Hawks & Doves, Living Together, Mass Hysteria! The next two days will be critical for global bond markets, with the U.S. Federal Reserve set to update its outlook for U.S. monetary policy. The only logical interpretation of current market pricing is that bond investors now expect a major hit to U.S. (and global) business confidence and economic growth from a U.S.-China trade war - without any lasting pickup in U.S. inflation from the tariffs. The Fed is stuck in a difficult position at the moment. Looking purely at the state of the economy, there is no immediate need for rate cuts. The unemployment rate is still low at 3.6%; real GDP growth was a solid 3.1% in Q1 and the Atlanta Fed’s GDPNow model estimates Q2 growth will be a trend-like 2.1%; and consumer confidence remains healthy. Our Global Duration Indicator has hooked up, driven by an improving global leading economic indicator and stabilizing economic sentiment surveys. Yet despite this, U.S. Treasury yields have melted down to levels consistent with much weaker economic growth and inflation, with -83bps of Fed rate cuts now discounted over the next twelve months (Chart of the Week). Chart of the WeekToo Much Economic Pessimism Now Discounted In U.S. Treasury Yields Chart 2U.S. Business Confidence: Fraying On The Edges The only logical interpretation of current market pricing is that bond investors now expect a major hit to U.S. (and global) business confidence and economic growth from a U.S.-China trade war - without any lasting pickup in U.S. inflation from the tariffs. Reducing interest rates now would be the appropriate pre-emptive policy response, even if the current health of the economy does not justify a need to ease. A look at various U.S. business confidence surveys confirms that interpretation. Both the NFIB Small Business Confidence index and the Duke CFO U.S. Economic Outlook index are still at fairly high levels, but have clearly softened in recent months (Chart 2, top panel). The deterioration in the Duke CFO measure has come from a sharp fall in the percentage of respondents who are more optimistic on the U.S. economic outlook – a move mirrored by the deterioration in the Conference Board’s survey of CEO Confidence (second panel). On the inflation side, the Duke CFO survey shows that companies have dramatically cut back on their planned increases for labor compensation over the next year, from 5.1% in the March survey to 3.8% in the June survey (third panel). Plans for price increases over the next year have also collapsed from 2.7% to 1.4% in the June survey (bottom panel). As the FOMC deliberates, the doves will make the following case for an insurance rate cut now (Chart 3): The U.S. manufacturing sector has caught up with the global downturn. Market-based inflation expectations remain below levels consistent with the Fed’s 2% PCE inflation target (between 2.3% and 2.4% using CPI-based TIPS breakevens). The 10-year/3-month U.S. Treasury yield curve remains inverted, typically a sign that monetary policy has become restrictive. The trade-weighted dollar remains near the post-crisis highs, even as U.S. bond yields have plunged. Global economic policy uncertainty remains elevated. Meanwhile, the hawks on the FOMC will argue that easing would be premature (Chart 4): Chart 3The Case For Fed Rate Cuts Chart 4The Case Against Fed Rate Cuts U.S. equities are only 2% below the all-time high. High-yield spreads are stable and nowhere close to the peaks seen during previous bouts of market turmoil. A similar argument applies for market volatility, with the VIX index also relatively subdued in the mid-teens. Global leading economic indicators are bottoming out. Underlying realized inflation trends – average hourly earnings growth, trimmed mean inflation measures – are sticky, at cyclical highs. Given the compelling arguments on both sides, the most likely outcome tomorrow will be the Fed holding off on cutting rates, but making a clear case for what it will take to ease at the July 30-31 FOMC meeting. We imagine that checklist to include: a) Failure of U.S.-China trade talks at the G-20 summit later this month to progress toward an agreement. b) The June U.S. Payrolls report, to be released on July 5th, confirming that the soft May reading was not a one-off. c) The June Consumer Price Index report to be released on July 11th, and the May PCE deflator reading out on July 28th, showing no acceleration of some of the “transitory” components that the Fed believes has been dampening U.S. core inflation. d) A major pullback in U.S. equities and/or a widening of U.S. corporate bond spreads, leading to tighter U.S. financial conditions. Chart 5The Market & FOMC Disagree On The Terminal Rate A new set of FOMC economic projections will be unveiled at this meeting, providing the intellectual cover for the Fed to signal that a rate cut is imminent. A new set of interest rate projections will also be provided. While this current edition of the FOMC has been downplaying the importance of the message implied by those interest rate projections, any movement in the “dots” will be noticed by the markets. The dot plot has only existed in a phase of expected Fed tightening. A shift to a projected ease would be momentous. In particular, any shift in the longer run “terminal rate” dot would be critical to ascertaining the Fed’s reaction function (Chart 5). This is especially true given the wide gap between our estimate of the market expectation of the terminal funds rate for this cycle (the 5-year U.S. Overnight Index Swap rate, 5-years forward, which is currently at 2%) and the median FOMC member estimate of the terminal rate from the last set of economic projections in March (2.8%). If the Fed were to make the case for an insurance rate cut tomorrow, while also lowering the terminal rate estimate, this would suggest that the FOMC was growing more concerned over the medium-term economic outlook as fewer future rate hikes would be needed. More dovish guidance on near-term rate moves, but without any change in the terminal rate projection, would imply that the Fed would view any insurance rate cut as a temporary measure that would need to be reversed at a later date if global uncertainty abates, U.S. growth recovers and U.S. inflation rebounds. Whatever the outcome of this week’s FOMC meeting, U.S. Treasury yields now discount a lot of bad news on both growth and inflation. Both the real and inflation expectations component of the benchmark 10-year Treasury yield are at critical support levels (Chart 6), suggesting that yields can only decline further in the face of incrementally more bearish economic data. Given the risk/reward tradeoff of yields at current levels, we do not recommend chasing this Treasury market rally, and prefer to position for an eventual rebound in yields. Chart 6Not Much Downside Left For Treasury Yields It is possible that the Fed gives a message this week that is more hawkish than the market expects, similar to last December, leading to a sharp selloff in risk assets that temporarily pushes the 10-year Treasury yield to 2%. Such an outcome would eventually force the Fed’s hand to cut rates down the road to offset the tightening of financial conditions and stabilize equity and credit markets. This will eventually trigger a rebound in Treasury yields via rising inflation expectations and investors’ moving out of bonds into risky assets. Given the risk/reward tradeoff of yields at current levels, we do not recommend chasing this Treasury market rally, and prefer to position for an eventual rebound in yields. Bottom Line: Depressed U.S. Treasury yields now discount more rate cuts than the FOMC is likely to deliver, even for “insurance” purposes to offset the negative growth impacts from trade policy uncertainty. Maintain a below-benchmark strategic U.S. duration stance, and stay underweight the U.S. in global hedged government bond portfolios. JGBs As A Duration Management Tool In Global Bond Portfolios It has been quite some time since we have discussed Japanese government bonds (JGBs) in this publication. That is for a good reason – they are an incredibly boring asset. We can think of many more interesting investments than a bond market with no yield, no volatility, no inflation and a central bank with no other viable policy options. Yet low Japanese interest rates make borrowing in yen a good source of funding for carry trades. JGBs also offer the usual safe-haven appeal during periods of risk aversion and recessions. JGBs are a low-beta sovereign bond market, making them a useful way to manage duration risk in a global bond portfolio – especially in environments like today, where JGB yields are higher than U.S. Treasury yields on a currency hedged basis (in U.S. dollars). Chart 7JGBs Are Essentially A 'Global Duration' Bet Most relevant for global bond investors - JGBs typically outperform their developed market peers during periods of rising global bond yields, and vice versa. That can be seen in Chart 7, where we show the total return of the Barclays Bloomberg Japan government bond index, hedged into U.S. dollars, on a duration-matched basis to the Global Treasury index. That return is plotted versus the overall Global Treasury index yield-to-maturity. The correlation is clear from the chart: JGBs outperform when the global yield rises, and underperform when the global yield is falling. In other words, JGBs are a low-beta sovereign bond market, making them a useful way to manage duration risk in a global bond portfolio – especially in environments like today, where JGB yields are higher than U.S. Treasury yields on a currency hedged basis (in U.S. dollars). For bond investors with a view that U.S. Treasury yields have fallen too far and are likely to begin rising again, JGBs are a compelling alternative. Selling Treasuries for JGBs, and hedging the currency risk back into U.S. dollars, can be a way to gain a yield pickup while reducing sensitivity to U.S. bond yield changes (i.e. duration) by owning an asset with a low, or even negative, beta to Treasuries. Chart 8BoJ Needs To Ease, But Options Are Limited Japan’s export-led economy is sputtering on worries over U.S.-China trade tensions which are dampening global growth sentiment more broadly. The Bank of Japan’s (BoJ) widely-watched Tankan survey shows that business confidence has turned more pessimistic; the manufacturing PMI has fallen below 50; and the OECD leading economic indicator for Japan is falling sharply. Even with the unemployment rate at a multi-decade low of 2.4%, wage growth remains muted and consumer confidence is softening. Our own BoJ Monitor is signaling the need for easier monetary policy, and there are now -9bps of rate cuts discounted in the Japanese Overnight Index Swap curve (Chart 8). The BoJ’s policy options, however, are limited. The official policy rate (the discount rate) is already negative, and pushing that lower risks damaging Japanese bank profitability even further. More dovish forward guidance is of limited impact with markets already priced for a prolonged period of low rates. The BoJ cannot pursue more quantitative easing (QE) either, as it already owns nearly 50% of all outstanding JGBs - a massive presence that has, at times, disrupted functionality in the JGB market. There is nothing on the horizon indicating that JGB yields will move much from current levels, allowing JGBs to maintain their defensive status in global bond portfolios. The only real policy tool left is Yield Curve Control (YCC), where the BoJ has been targeting a 10-year JGB yield close to 0% and managing purchases to sustain the yield target. In our view, any upward adjustment of that yield target range (currently 0-0.2% on the 10yr JGB) would require a combination of three factors: The USD/JPY exchange rate must increase back to at least the 115-120 range, to provide a lower starting point for the likely yen appreciation that would occur if the BoJ targeted a higher bond yield. Japanese core CPI inflation and nominal wage growth must both rise and remain above 1.5%, which is close enough to the BoJ’s 2% inflation target to justify an increase in nominal bond yields. The momentum in the yield differential between 10-year Treasuries and JGBs must be overshooting to the upside; the BoJ would not want to keep JGB yields too depressed for too long if the global economy was strong enough to boost non-Japanese yields at a rapid pace. Chart 9BoJ Yield Curve Control Is Here To Stay Currently, none of those criteria is in place (Chart 9). USD/JPY is down to 108; core CPI inflation is 0.6%; real wage growth is effectively zero; and the 10yr U.S.-Japan bond spread is contracting. There is nothing on the horizon indicating that JGB yields will move much from current levels, allowing JGBs to maintain their defensive status in global bond portfolios. Changes to our model bond portfolio We have been recommending an overweight stance on JGBs in our model portfolio for much of the past two years. This is in line with our long-held view that global bond yields had to rise on the back of improving global growth and the slow normalization of interest rates by the Fed and other central banks not named the Bank of Japan. Events this year have obviously challenged that view and we have reduced the size of our recommended overweight in our model bond portfolio. Given our view that U.S. Treasury yields are likely to grind higher in the next few months, we see a need to turn to Japan as a way to play defense against a rebound in global bond yields. That means increasing the Japan allocation, and decreasing the U.S. allocation, in our model bond portfolio. We can fine-tune that allocation shift based on the empirical yield betas of U.S. Treasuries to JGBs across different maturity buckets. In Chart 10, we show the rolling 52-week yield beta of JGBs to the other major developed bond markets, shown at the four critical yield curve points (2-year, 5-year, 10-year and 30-year). In all cases, the yield beta is low and fairly consistent across all maturities. When looking at those same rolling betas using yields hedged into U.S. dollars, shown in Chart 11, the story changes (note that we are using hedged yield data from Bloomberg Barclays, so the maturity buckets correspond to those used in the benchmark indices). The yield betas between JGBs and other markets are at or below zero in the 3-5 year and 7-10 year maturity buckets, with particularly large negative betas versus U.S. Treasuries. This implies that there is a gain to be made by focusing any Japan-for-U.S. switch in currency-hedged global bond portfolios on bonds with maturities between three and ten years. Chart 10JGBs Are Low-Beta To Global Yields... Chart 11...And Even Negative-Beta After Hedging Into USD Based on this analysis, and our view on U.S. Treasuries laid out earlier in this report, we are making a shift in our model bond portfolio on page 12 – cutting the weight in the maturity buckets in the middle of the Treasury curve and placing the proceeds into similar maturity buckets in Japan. Bottom Line: The low yield beta of Japanese government bonds can be a useful diversifier of duration risk in global government bond portfolios. We recommend taking advantage of this by increasing allocations to Japan, out of U.S. Treasuries, on a currency-hedged basis (into USD). Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights June FOMC Meeting: To appease markets, the Fed will at least have to signal that it stands ready to cut rates in July. While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit spreads in the near-term (0-3 months). Rate Cuts: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates in June or July. Treasury Yields: Yields have fallen a lot since the beginning of November, but the move isn't terribly anomalous relative to history. We use statistics to place recent price action in its appropriate historical context. Feature The Fed This Week Chart 1Credit Spreads At Risk Tomorrow’s FOMC meeting is the main event in financial markets this week, with investors of all stripes eager to learn whether the Fed will deliver on the rate cut expectations that have already been priced into bond yields. As we’ve written in prior reports, our immediate concern is that the Fed may not sound dovish enough to appease markets, leading to further near-term widening in corporate bond spreads.1 Corporate bond excess returns have far outpaced commodity prices of late (Chart 1), leaving the sector vulnerable to any hawkish surprise. What’s Priced In, And Can The Fed Deliver? How dovish must the Fed be to prevent a sell-off in corporate credit? A look at current fed funds futures pricing shows that the market is looking for nearly three 25 basis point rate cuts spread over the next six FOMC meetings (Table 1). Roughly, the market expects one rate cut at either the June or July meeting, a second rate cut in either September or October, and a third rate cut in either December or January. To appease markets, the Fed will at least have to revise its 2019 funds rate projections down and signal that it stands ready to cut rates in July (Chart 2). While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit markets in the near-term (0-3 months). Table 1Fed Funds Futures: What's Priced In? Chart 2Watch For Dot Plot Revisions Fed Rate Cuts: A Track Record While we are cautious on corporate spreads in the near-term, we are also not willing to chase Treasury yields lower from current levels. Our view is that while the Fed might deliver a rate cut at one of the next few meetings, it is unlikely to lower rates by more than the 84 bps that are priced into the yield curve for the next 12 months. Ultimately, we expect Treasury yields to be higher on a 6-12 month horizon, even if the Fed cuts rates during the next few months. In response to this outlook, a few clients have asked whether it is possible for Treasury yields to rise so soon after a Fed rate cut. While we see no theoretical reason why it shouldn't be possible, it is always a good idea to stress test a theory against the historical track record. We therefore compiled a list of every Fed rate cut since 1995, and looked at how the 10-year Treasury yield reacted to each event. The results are displayed in Tables 2A-2D. Table 2A shows the rate cuts that the Fed delivered in the mid-1990s, in response to persistently low U.S. inflation and slowing growth in the rest of the world. At the time, overall U.S. economic growth was quite solid and the U.S. economy didn’t fall into recession until 2001. The divergence between relatively strong U.S. economic growth and slower growth in the rest of the world makes the period look very similar to today, and we have long argued that the current cycle should be viewed in the context of the mid-1990s.2 Table 2A reveals that, on average, the 10-year Treasury yield tended to rise in the months following a rate cut, often even in the first 21 days. The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. Table 2C shows the rate cuts that were delivered during the economic recovery of the mid-2000s, and it paints a similar picture as Table 2A. In particular, the 10-year Treasury yield rose dramatically following the 2003 rate cut, and the Fed actually started to hike interest rates almost exactly one year after the 2003 cut. Tables 2B & 2D show the rate cuts that led into the 2001 and 2008 recessions. Not surprisingly, yields were much more likely to fall after the Fed cut rates in those episodes. Bottom Line: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. The yield is much more likely to fall if the cut occurs in the run-up to a recession. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates at one of the next few FOMC meetings. Treasury Yield Moves: A Track Record In recent weeks a BCA client who had been shaking his head at the large drop in Treasury yields reached out to see if we could put the recent moves in historical context. Specifically, he wondered how often such large yield moves have occurred in the past, and whether there is a tendency for moves of this magnitude to mean-revert. Our U.S. Investment Strategy team took a stab at answering these questions. The below analysis first appeared in last week's U.S. Investment Strategy report, but is re-printed here for the interest of U.S. bond clients.3 The ongoing decline in bond yields has felt like a big deal in real time, but it isn’t historically. The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 3). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 3). Chart 3The Path To 2.07% Table 3A Lower 10-Year Treasury Yield In Three Steps Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 4). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 4Standardized Values Of Nominal 10-Year Treasury Yield Declines The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 4). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 5). Chart 4No Historical Anomaly In The Current Market Chart 5Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.4 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The standardized moves in real yields and Treasury index returns haven’t been a big deal. Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 6). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 6Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 7). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 8). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. Chart 7... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 8... And Long-Maturity Returns Have Been Elevated The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, and history suggests it will be partially unwound over the next six to twelve months. Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 5). Table 5Standardized Values Of Future Long-Maturity Treasury Index Returns Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 6). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. Table 6Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Investment Strategy Weekly Report, “Context”, dated June 10, 2019, available at usis.bcaresearch.com 4 If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%). Fixed Income Sector Performance Recommended Portfolio Specification
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Our main justification is that such a large number of rate cuts will only occur if the economy enters a recession. At present, the pre-conditions for an economic recession are simply not in place. Rather, the economy is experiencing an external shock – akin…