Developed Countries
Highlights Duration & The Fed: With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. Duration & The CBO: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. The Bond Map: This week we introduce a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. Feature If we had to choose a fundamental first principle of bond investing, it would be that investors should determine what change in the short-term interest rate is currently priced into the market and then decide whether the central bank will move the interest rate by more or less than what is discounted. Using a 12-month investment horizon, Chart 1 shows that the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.1 It also shows that the market has underestimated the Fed's hawkishness since early 2016, leading to a negative price return for Treasuries. This stands in stark contrast to earlier in the recovery when the market consistently anticipated more rate hikes than were ultimately delivered (Chart 2). Chart 1The Fundamental Question Chart 2Investors Have Been Surprised By Fed With all that in mind, in this week's report we consider whether the Fed will continue to deliver hawkish surprises during the next 12 months. Or whether market expectations have finally caught up with reality. The Near-Term Rate Hike Outlook The first step in our "back to basics" bond analysis is to assess what rate hike outlook is currently priced into the yield curve. Using overnight index swap (OIS) forwards, we calculate that the market expects the federal funds rate to be 68 basis points higher in one year's time. Alternatively, we can calculate that the market expects a federal funds rate of 2.23% by the end of this year, 2.63% by the end of 2019, and 2.69% by the end of 2020 (Chart 3). The federal funds rate is currently 1.69%. Adopting the 12-month time horizon used in Chart 1, we can say that the market expects 2-3 rate hikes between now and next April. This is slightly below the Fed's current projections. As of the March FOMC meeting, 12 out of 15 FOMC participants anticipated delivering either 2 or 3 more rate hikes before the end of the year. With another 2-3 hikes anticipated in 2019, it is clear that the FOMC is somewhat more hawkish than the market. But even with a more hawkish outlook than the market, the FOMC still expects core inflation to modestly overshoot its 2% target during the next two years (Chart 4). We view this as a reasonable expectation. While core PCE inflation increased at a year-over-year pace of only 1.6% through February, we showed last week that base effects will cause it to jump sharply in March.2 A month-over-month increase of 0.1% in March translates to a year-over-year growth rate of 1.85%. A month-over-month increase of 0.2% translates to a year-over-year growth rate of 1.95%. As long as the economic recovery is sustained it is not far-fetched to expect that inflation will reach the Fed's target before the end of the year. Chart 3Market Versus Fed Dots Chart 4Fed Projects An Inflation Overshoot Once inflation reaches (or exceeds) the Fed's 2% target, it will necessitate a change in communication from the central bank. Specifically, with the Fed's inflation goal having been achieved, it would be inappropriate for it to maintain an "accommodative" monetary policy. The Fed discussed this eventuality for the first time at the March FOMC meeting, as evidenced by this passage from the minutes: Some participants suggested that, at some point, it might become necessary to revise statement language to acknowledge that, in pursuit of the Committee's statutory mandate and consistent with the median of participants' policy rate projections in the SEP, monetary policy eventually would likely gradually move from an accommodative stance to being a neutral or restraining factor for economic activity.3 The bottom line is that with inflation quickly approaching the 2% target, the Fed is unlikely to deviate from its gradual pace of rate hikes. With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. The Importance Of The Equilibrium Fed Funds Rate Chart 5Potential GDP Growth ##br##Revisions Are Cyclical Another factor that will govern the cyclical outlook for Fed rate hikes is the equilibrium level of the federal funds rate. That is, the level of interest rates that is consistent with neither an accommodative nor a restrictive policy stance. The level that is expected to keep inflation more or less stable. From the most recent Summary of Economic Projections we know that most FOMC members think that the equilibrium fed funds rate is in the vicinity of 3%, while the bottom panel of Chart 3 shows that market prices embed a somewhat lower forecast. The importance of the equilibrium rate is that if it turns out to be higher than the market expects, then the central bank will be forced to deliver more rate hikes than are anticipated, leading to negative bond price returns, as shown in Chart 1. But how do we judge the appropriate level of the equilibrium fed funds rate? One way is to recognize that the equilibrium fed funds rate is theoretically linked to the rate of potential GDP growth. In fact, we observe that market expectations for the equilibrium fed funds rate - as measured by the 5-year/5-year forward OIS rate - closely track the Congressional Budget Office's (CBO) forecast for potential GDP growth during the next 5 years (Chart 5). Notice that the increase in the 5-year/5-year OIS rate since mid-2016 coincides with upward revisions to the CBO's potential GDP growth projections. Chart 6Determinants Of The Growth##br## Of Real Potential GDP This brings up another important point. Because potential GDP growth is not easily measurable, it is often revised higher during periods when GDP growth strengthens and lower during periods of weaker growth (Chart 5, bottom 2 panels). This raises the possibility of further upward revisions if GDP growth remains strong. We certainly wouldn't rule out that possibility, but we also view the scope for further upward revisions to potential GDP growth as fairly limited. Chart 6 shows the breakdown of the CBO's potential GDP growth forecast between its two components: The size of the labor force Labor force productivity The CBO currently projects potential GDP growth of 2% (annualized) for the next 5 years, split between 0.6% annual growth in the size of the labor force and 1.4% annual growth in labor force productivity. Since projections for the size of the labor force are largely driven by slow-moving demographic factors, they are less subject to revision than are projections for the more nebulous productivity component. But with the CBO already embedding a forecast of 1.4% for annual productivity growth, how much higher can we reasonably expect it to be revised? The current forecast is already consistent with the productivity growth that was realized during the 2002-07 period. Any further upward revisions would cause productivity growth to approach the 2% level that was realized during the I.T. revolution of the 1990s. That seems overly optimistic. Bottom Line: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. A Quick Note On The Tactical House View Yesterday morning, BCA strategists decided to downgrade our tactical (0-3 month) view on global equities from overweight to neutral, while simultaneously upgrading the tactical view on global bonds from underweight to neutral.4 All cyclical (6-12 month) views remain unchanged. The two main reasons for the tactical shift are the moderation in global growth, which was flagged in this publication last week, and the long list of potential geopolitical risks that could roil markets in May and June.5 Of course any flare-up of geopolitical risk would lead to a near-term spread widening and a flight-to-quality into Treasury bonds. But while investors should certainly be aware of the near-term risks, we are not altering our cyclical portfolio recommendations. Unanticipated inflation remains the number one risk for bond markets. A re-anchoring of the 10-year TIPS breakeven inflation rate will apply 17 bps to 27 bps of upward pressure to the nominal 10-year Treasury yield, and we are likewise inclined to wait for inflation expectations to re-normalize before positioning for any sustained widening in corporate spreads. Navigating The Bond Map This week we introduce a new framework for judging the relative risk/reward trade-off between different sectors of the U.S. bond market. We dub this framework the Bond Map, as it gives us a quick glimpse of how different sectors stack up against one another. In this section we describe how the Bond Map is created, and we will introduce further applications of the Bond Map in the coming weeks. The Total Return Bond Map Chart 7 presents our Total Return Bond Map. The vertical axis of the Map represents the potential reward available in each sector. Specifically, the numbers on the vertical axis correspond to the number of days of average yield decline that are required for each sector to earn a total return of 5% over a 12-month period. For example, it would take 10 days of average yield decline for the Treasury index to deliver a 5% return, it would only take 4 days for the investment grade Corporate index to deliver the same return. Therefore, unsurprisingly, the potential for reward is greater in the investment grade corporate bond index than in the Treasury index. To calculate the number of days to earn 5%, we start with the following formula that relates the total returns for the index to its average yield, duration and convexity. Total Return = Yield - Duration * (Change in yield) + 0.5*Convexity*(Change in yield)2 We set the total return threshold to 5% and use 1-year trailing yield volatility as an estimate for the squared change in yields. This allows us to calculate the change in yields required for the index to return 5%. Lastly, we adjust the change in yields by the yield volatility of each index. Starting in 2000, we look at a sample consisting only of days when the average yield of the index declined, and we calculate the average magnitude of the yield decline on those days. We then divide the yield change required to gain 5% by the average magnitude of the daily yield decline. The result is a measure of the probability of earning a 5% return that should be roughly comparable between different bond sectors. The horizontal axis is the mirror image of the vertical axis. It is the number of days of average yield increase required for the index to lose 5%. This is calculated using the same process described above, except we use a total return target of -5% and calculate average daily yield changes using only days when yields increase. Once again, the result is a measure of the probability of losing 5% that is roughly comparable between different sectors. One way to interpret the Total Return Bond Map is to split it into quadrants centered on the Bloomberg Barclays U.S. Aggregate Index. Sectors that plot in the upper-right quadrant are exciting sectors that provide a high probability of earning 5% but also a high probability of losing 5%. Conversely, sectors in the bottom-left quadrant are the boring sectors that provide a low probability of losses, but also a low probability of gains. More interesting are those sectors that plot in the upper-left and bottom-right quadrants. Those sectors in the upper-left (High-Yield bonds and Municipal bonds adjusted for the top marginal tax rate) provide both a higher probability of gains and a lower probability of losses than the Aggregate. Conversely, those sectors in the bottom-right quadrant (Treasuries) provide both a lower probability of gains and a higher probability of losses. One counterintuitive result that springs from the Total Return Bond Map is that the High-Yield index appears less risky than the Treasury index. But upon closer inspection the reason for this appears obvious. The average yield on the junk index needs to rise by approximately 250 bps for the index to lose 5%. Because of its lower carry buffer, the average Treasury index yield needs to rise by only about half as much. At the same time, while the volatility of junk yields is higher than the volatility of Treasury yields, it is not twice as high and therefore does not fully offset the yield advantage in high-yield bonds. The main reason for this is the negative correlation between Treasury yields and high-yield spreads. Usually when Treasury yields are rising, high yield spreads are tightening, and vice-versa. This moderates the volatility in junk yields. To see how the sectors in the Total Return Bond Map move around over time, Chart 8 presents what the Total Return Bond Map looked like on January 1, 2010. We see that high-yield bonds looked even more attractive in early 2010, as did 30-year conventional MBS and Aaa-rated non-Agency CMBS. Chart 7Total Return Bond Map (As Of April 12, 2018) Chart 8Total Return Bond Map (As Of January 1, 2010) The Excess Return Bond Map Chart 9 presents the same Bond Map as above, except now we consider excess returns relative to duration-matched Treasuries rather than total returns for each index. We also set our excess return threshold for gains and losses at +/- 100 bps, rather than the 5% we used for total returns. All other calculations remain the same, except that we use spreads and spread volatilities as our inputs rather than yields. Chart 9 shows that the investment grade corporate, local authority and foreign agency sectors look most attractive in excess return space. While no sectors plot in the bottom-right "avoid" quadrant relative to the Bloomberg Barclays Aggregate. Chart 10 once again shows the same Bond Map as of January 1, 2010, and once again the attractiveness of Aaa-rated non-Agency CMBS is apparent. Meanwhile, conventional 30-year MBS looked unattractive in excess return space in early 2010. In the Excess Return Bond Map, you will notice that some sectors actually have a negative number of days of spread tightening required to earn +100 bps. This simply means that spreads could actually widen somewhat and, because of the large carry buffer, the sector would still produce excess returns of +100 bps. Bottom Line: This week we introduced a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. While this framework does not impose a macro view, it does seem to provide a good starting point for assessing relative risk-adjusted value in U.S. bonds. We will continue to refine the approach and search for applications in the coming weeks. Chart 9Excess Return Bond Map (As Of April 12, 2018) Chart 10Excess Return Bond Map (As Of January 1, 2010) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Market expectations are calculated from the overnight index swap curve. 2 Please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com 3 SEP = Summary of Economic Projections 4 A summary of all BCA house views can be accessed here: www.bcaresearch.com/trades/ 5 For details on the trend in global growth please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com. For details on potential geopolitical risks during the next few months please see Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Overweight The S&P containers & packaging index has been recovering in the past few sessions. This follows being caught in the downdraft all global trade-exposed stocks have been reeling from; now fears of a generalized trade war appear to be receding. Certainly the geopolitical spats have not been making themselves present in real trade data; the global export volume index published by the CPD Netherlands Bureau for Economic Policy Analysis has, in fact, been accelerating recently to its current record high level (second panel). As global trade seems set to move higher regardless of political machinations, domestic demand remains resilient. Real spending on food and beverage, the key customer group of containers & packaging companies, has been expanding uninterrupted for the past two years, implying solid sector top line growth (third panel). At the same time, producer prices, despite having rolled over somewhat, are still rising (bottom panel). While spiking pulp prices will eat into margins, we expect a soft dollar to offset via the export channel. Net, we would buy into any weakness in this sector; we reiterate our overweight recommendation in this niche materials sector. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.
Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Overweight (High Conviction) America's largest banks are set to kickstart earnings season at the end of this week/beginning of next week and, with a 25% improvement in EPS forecast by sell side analysts this year, expectations are high. We think deservedly so. Our high-conviction overweight thesis remains unchanged; bank profits should outperform the broad market as the price of credit, loan growth and credit quality are all tailwinds in 2018. Rising inflation expectations (second panel) should support the 10-year yield, driving improving net interest margins. Positive sentiment should mean that bankers keep the credit taps open to sustain the broad capex upcycle (third panel). Combined with record low unemployment and the associated low default rates, margins should widen. Our banks EPS model (bottom panel) incorporates these factors and continues to point to significant earnings upside in the year to come. Accordingly, we reiterate our high conviction overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. 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-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart 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##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... Chart 11...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Chart 16Likely No Majority In Congress Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Chart 18Mexico's Rising Political Plurality Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Chart 20A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Chart 22Abe Holding At Koizumi's Levels Of Support More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.
Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.