Developed Countries
Highlights The so-called 'Silver Tsunami' of retiring baby boomers will continue to be a drag on aggregate wage growth for some time. We would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. Overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The global inflation mini-cycle will turn down in early 2018. Approaching the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Feature Last week, the Bank of England pointed out that "some of the softness in recent pay outturns had related to the composition of employment, with the number of low-paid jobs growing disproportionately."1 Separately, a recent study by the Federal Reserve Bank of San Francisco described the exact same phenomenon in the United States. "The drag on wage growth reflects changes in workforce composition."2 The San Francisco Fed study highlighted two paradoxes. The first paradox is that for continuously full-time employed workers, wages are actually rising quite strongly. For the continuously employed, pay is growing close to the rate seen at the previous economic peak in 2007 (Chart I-2). Chart of the WeekThe Inflation Mini-Cycle Will Turn Down In Early 2018 Chart I-2Will The Real Wage Inflation Please Stand Up However, the entry of new and returning workers to full-time employment continues to depress aggregate wage growth - because new entrants generally earn less than workers who are leaving full-time employment. This creates the second paradox. Strong job growth can actually pull down average wages in the economy and slow the pace of aggregate wage growth. Solving The Wage Puzzle According to the San Francisco Fed, this 'composition effect' is exceptionally pronounced right now because of the large-scale exit of higher-paid baby boomers from the labour force. This has depressed aggregate wage growth by 2 percentage points, a sizeable effect relative to the normal expected wage gains. Furthermore, with so many of the baby boomer generation still approaching retirement, "the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time." A second very important factor is at play. The current wave of technological progress is having its most disruptive impact on middle-income jobs. As we explained in Why Robots Will Kill Middle Incomes,3 "high-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources." The upshot is that when baby boomers retire, automation and Artificial Intelligence (AI) are replacing many of the jobs that the boomers occupied in high-income and middle-income sectors such as Finance and Manufacturing, rather than opening up these formerly lucrative career paths to new entrants. Therefore, new entrants are flooding into industry sectors which AI cannot yet disrupt but which are traditionally much lower paid with limited prospects for advancement - sectors like Food Services and Drinking Places and Administrative and Support Services (Table I-1). Table I-1Which Sectors Are Creating The Most Jobs? In summary, for the continuously employed, wages are rising healthily. But for aggregate wage growth, the composition effect from retirements and new entrants is an exceptionally strong headwind. What does this mean for overall inflation? The study concludes that as long as the economy can keep its wage bill low by replacing retiring staff with AI and with lower-paid workers, "labour cost pressures for higher price inflation could remain muted for some time." Given that the next wave of AI is just about to hit us, we expect these conditions to hold true in all developed economies for at least the next five years. Solving The U.K. Productivity Puzzle Chart I-3Since The Global Financial Crisis U.K. ##br##Productivity Has Stagnated But the San Francisco Fed study does also carry a warning about a latent inflationary threat. If productivity growth is slowing, "continued increases in unit labour costs could be hiding behind low readings on measures of aggregate wage growth." This seems to be a particular worry in the U.K. Since the global financial crisis, serial disappointments in productivity growth have concerned the Bank of England (Chart I-3). However, the Bank need not worry. We would like to present a very simple explanation for the U.K.'s so-called 'productivity puzzle'. Big clues come from comparing and contrasting the economic recoveries of 1993-2000 with 2009-17. At the very beginning of the two recoveries, productivity growth evolved in the same way. But then it took drastically different paths. Through the late 1990s, productivity growth accelerated, whereas through the 2010s productivity has stagnated. Why? A plausible explanation comes from the mirror-image patterns in self-employment. At the very beginning of the two recoveries, self-employment evolved in the same way. But through the late 1990s self-employment fell by 300,000, whereas through the 2010s self-employment has increased by a million, accounting for 30% of all jobs created (Chart I-4, Chart I-5, Chart I-6, Chart I-7). Furthermore, there is a tell-tale pattern. Whenever self-employment has picked up most sharply - for example, 2011-13 and 2015 - productivity growth has taken a big hit. Chart I-41990s Recovery: ##br##Self-Employment Fell Chart I-52010s Recovery: Self-Employment ##br##Has Risen Sharply Chart I-6Compare And Contrast: ##br##The Pattern of Self-Employment... Chart I-7...And Productivity...##br##Are Mirror-Images What's going on? Contrary to popular belief, the self-employed are not innovative entrepreneurs, who might typically boost productivity. The Office for National Statistics itself has poured cold water on the increased innovation thesis, claiming that "while there has been an increase in the number of people who are self-employed there has been a reduction in the number of employees who work for the self-employed." Given that these new self-employed work for themselves with no employees of their own, the idea that they are innovative entrepreneurs is a long way from the truth. In reality, the new model army of self-employed consists of former employees in sectors like journalism, media and technology who are now freelancing. And this provides a simple explanation for the productivity puzzle. Job creation that is skewed to self-employment depresses productivity growth. The reason is that the army of self-employed have to carry out tasks in which they have no specialism, and in which they are therefore much less productive. For example, a freelance journalist must spend time managing her IT gremlins, accounts, sales pitches, and so on, rather than focussing entirely on her special skill of writing powerful news stories. This makes her much less productive as a freelancer than as an employee. However, this hit to productivity eventually abates in one of two ways: freelancers gradually become more adept at the new tasks they must undertake; or more likely, they switch back to employee jobs in which they are much more productive. Combining the messages from the first two sections, the Bank of England need not fear labour cost pressures for higher price inflation. Furthermore, with Brexit negotiations progressing at a snail's pace, U.K. based companies are getting increasingly nervous about what their future international trading relationships will look like. So we would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. The investment conclusion is to overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The Inflation Mini-Cycle Will Turn Down In Early 2018 Last week, we reviewed our mini-cycle framework for the global economy. To recap, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern with each half-cycle lasting about 8 months. As the current mini-upswing started in May, we are likely more than half way through the mini-upswing - with an expected end around January/February 2018. At which point, the cycle will enter a mini-downswing. The mini-cycle framework is so powerful that it also perfectly explains the mini-cycles in commodity price inflation - specifically, metals - and unsurprisingly, in overall inflation too. To anybody who still doubts the existence of these remarkably regular mini-cycles, the Chart of the Week and Chart I-8 should put the doubts to rest once and for all. Chart I-8Metal Price Inflation Also Exhibits Remarkably Regular Mini-Cycles Make no mistake. The mini-cycle in commodity prices and overall inflation will turn down in early 2018. So as we approach the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From the Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on November 1, 2017. 2 From the SF Fed blog 'The Good News on Wage Growth' August 14. 2017. 3 Please see the European Investment Strategy Special Report 'Why Robots Will Kill Middle Incomes' August 10, 2017 available at eis.bcaresearch.com. Fractal Trading Model* The near 20% rally in Japan's Nikkei 225 since early September has taken its 65-day fractal dimension to its lower bound, suggesting a likelihood of a trend-change. So our recommended trade this week is short Nikkei 225 / long Eurostoxx50 with a profit target / stop loss set at 3%. We now have six 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-9 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 The bill is bullish for growth and therefore for the equity markets and the U.S. dollar; The bill consists mostly of tax cuts, not reforms, that favor corporations and the wealthiest taxpayers; The bill is bullish for growth in the short term, but also inflationary and hence a risk to growth in the medium term; A non-populist White House is a relief to the markets, particularly on trade policy, but may mean a more hawkish foreign policy. Feature Chart 1Trump: A Boon For##BR##Main Street And Wall Street Since the November 2016 election, and particularly since President Donald Trump's inauguration, financial markets have celebrated. This is ironic given that on the campaign trail, Trump often adopted populist rhetoric indistinguishable from that of Bernie Sanders, the bête noire of the business community. Trump's cabinet, however, quickly took on a pro-business outlook following the inauguration. Despite appointing several notable trade hawks, the administration sported half a dozen former Goldman Sachs employees. Business confidence soared, especially among small businesses, while regulatory worries hanging over CEO's melted away (Chart 1). Both Wall Street and Main Street took one look at President Trump's cabinet at the end of January and decided that there was not an iota of genuine populism in the White House. This view was reinforced by three early decisions by the Trump administration: China: President Trump reneged on his promise to designate China a currency manipulator formally on day one of his administration.1 Instead, he hosted President Xi Jinping at the Mar-A-Lago Summit in April and agreed to engage in trade talks over the rest of the year. (He again declined to accuse China of currency manipulation in October.) Budget: President Trump's "skinny budget" proposal in May oozed with Republican Party orthodoxy, bolstering spending on defense and border security, while calling for drastic cuts to domestic programs. The implication was that future tax cuts would ultimately be "paid for" via draconian fiscal austerity in the distant future. "Breitbart clique" ousted: Steve Bannon, the White House Chief Strategist and self-described economic nationalist, was fired in mid-August, with several prominent allies ousted in the wake of his departure. Bannon's departure left Treasury Secretary Steven Mnuchin, chief economic advisor Gary Cohn, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Enter Tax Cuts The coup-de-grâce of Republican orthodoxy is the just-proposed tax cut plan. The proposal by the House Ways and Means Committee is heavily stacked in favor of corporations and the top-income brackets. As Table 1 clearly illustrates, the household component of the plan is nearly balanced - and therefore deserving of the moniker "reform" - whereas the corporate side of the ledger is closer to a pure and simple cut. Table 12017-2018 Republican Tax Cut Proposal - House Ways And Means Committee (Oct. 2017) Some of the more prominent measures proposed by the House and Ways Committee are: Household Income The highest tax rate remains 39.6%, but would now only kick in at $1 million in taxable income;2 The Alternative Minimum Tax (AMT) will be repealed, which hurts the upper middle class and wealthy by limiting tax benefits from a variety of deductions; The estate tax will be fully eliminated by 2024; The standard deduction will be doubled from $12,700 to $24,000, one of the few direct benefits to lower-income families; The plan would repeal the state and local income and sales tax deductions, while capping the state and local property tax deduction to $10,000; Almost all itemized deductions will be eliminated - such as medical expenses, property losses, casualty losses, etc.; The mortgage interest rate deduction for future home purchases will be capped, with only homes up to $500,000 covered. Corporate Income The corporate tax rate will be cut from 35% to 20%; Companies will be able to deduct the full amount of business investments in the year that they are made, although the provision would expire at the end of 2022; The tax rate on income from pass-through businesses would fall to 25%, considerably below the top household income tax rate; Several deductions would be eliminated, including the deduction of interest on debt; The "worldwide" tax system would be overhauled and foreign earnings repatriated: U.S. multinational corporations would pay a 12% tax rate on past profits that they repatriate, while future overseas earnings would be taxed at the new 20% corporate rate. We would caution clients from parsing too carefully through the proposal, lest they waste their time. The Senate is likely to pass a completely different set of proposals. The GOP plan is to get to a "conference committee" as fast as possible, where a new draft legislation can be hammered out from the two disparate proposals. We suspect that this entire process will miss the self-imposed target of "before Christmas," and probably last until the end of the first quarter.3 Nonetheless, we can discern the priorities of the House Republicans by gauging the winners and losers of their proposal. Our immediate take is that the tax cuts greatly benefit upper-income filers (households making over $423,000), moderately hurt upper-middle-class / lower-upper-class filers (those making between $260,000 and $423,000), and are largely neutral for the rest of households. First, the highest income groups are the clear beneficiaries: households making between roughly $450,000 and $1,000,000 will see their income tax rates fall by nearly 5%, by far the largest decrease planned. And, obviously, it is upper-income households that benefit from repealing the estate tax. Meanwhile, the upper middle class takes on the brunt of the burden of "reform": households making between $260,000 and $423,000 will see far fewer benefits under the proposed legislation. First, they are the only income bracket that will see a tax increase, from 33% to 35%. Second, they will not necessarily have the wherewithal to reclassify their income as pass-through business income. Third, many of the itemized deductions that will be eliminated will make a real difference in their filings. Fourth, they were the most likely to purchase homes between $500,000 and $1,000,000, which will no longer be eligible for interest-rate deduction. Fifth, the repeal of the estate tax will make less of a difference for this income group. Sixth, if they are domiciled in high-tax rate states and municipalities, these households will now be limited to how much they can deduct from federal taxes.4 Overall, the proposed tax cut plan fits general Republican orthodoxy.5 It tries to stimulate growth by favoring corporations and the wealthy. For economic growth, the plan is bullish in the short term. Particularly bullish is the ability of corporations to fully deduct the amount of business investment for the next five years. This provision could significantly increase investment in the short term, especially given the implicit threat that the opportunity will expire in 2022.6 Will the plan fail? It could, if enough Republican voters turn against it. The latest polling from Pew research - albeit from April of this year - shows that Americans no longer think that they pay too much in taxes (Chart 2). On the other hand, Republican and Republican-leaning voters do have a problem with the complexity of the tax code (Chart 3), and the proposed plan simplifies taxes for some middle-income households by doubling the standard deduction and repealing the AMT. The White House has already begun stressing this feature given that it polls well with voters. Chart 2American Voters Think Taxes Are Fair... Chart 3...But Republican Voters Think They Are Too Complex Polling suggests that President Trump remains relatively popular with Republican voters despite his dismal polling with the general public (Chart 4). He is polling only slightly below the average of previous Republican presidents at this point in his term in office. As long as Trump remains more popular with Republican voters than his Republican peers in Congress, we think that he will be able to force the tax plan through both the Senate and the House. In fact, we could even see some Democrats in the Senate supporting these tax cuts. Table 2 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin) are especially vulnerable. That makes seven potential votes for the Trump tax cut, potentially enough "slack" for the Republicans in the Senate to lose one or two votes on the tax bill. Chart 4Trump Remains Popular With GOP Voters Table 22018 Senate Races To Watch Is it even worthwhile to contemplate a scenario in which Republicans pass the tax cuts with Democrat support in the Senate? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska) all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states. Bottom Line: The proposed tax cuts will benefit corporations and the upper-income Americans. The Senate may make some symbolic changes to the proposal to make it more palatable to the median American - given that senators have to capture the median voter in their state to win reelection. For example, the estate tax repeal may be scrapped and rules on deducting state and local taxes may be modified. Regardless of how the horse-trading goes, we believe that the U.S. economy will receive a modest stimulus in the form of a roughly $1.5 trillion tax cut (over ten years). Given that the U.S. economy is at full employment and firing on all cylinders, the proposed tax cuts should be marginally bullish for growth and inflation (Chart 5). Chart 5Regardless Of Tax Cuts, U.S. Economy Is Ripped What Do The Tax Cuts Tell Us About President Trump? We are big believers in the theory of "revealed preferences." While this concept was formally applied by economist Paul Samuelson to consumer behavior, we like to apply it to policymakers. The idea is to ignore the rhetoric and focus on what patterns of behavior reveal about genuine preferences. Politicians talk a lot, particularly during an election campaign. As a presidential candidate, Donald Trump was a clear populist candidate. He only revealed his tax reform plan in late September 2015 and then rarely mentioned it on the campaign trail. While his tax cut proposal languished on the campaign website, Trump focused on rallying voters around a combination of populist promises. These were, in no particular order, to build the border wall (and make Mexico pay for it), to rebuild American infrastructure, to repeal Obamacare, to destroy the Islamic State terrorist movement while disengaging the U.S. from global affairs, and to punish the unfair practices of trade partners like China and Mexico. Fast forward 12 months and we are now half-way to the 2018 mid-term election, with the Republicans controlling all three branches of government, and yet the only electoral promise that President Trump is even close to achieving is the just-announced tax cut.7 The revealed preference of the Trump administration, at least at this point, is Republican orthodoxy. Trump is a pro-growth, pro-business, anti-tax, anti-spending, red-blooded Republican. He has eschewed trade conflict with China, ignored infrastructure proposals, largely toed-the-line of foreign policy orthodoxy, and left hedge fund managers - a punching bag on the campaign trail - alone.8 To put it bluntly, Trump's behavior thus far suggests that he is a pluto-populist. A pluto-populist is someone who rules on the behalf of a plutocracy - an oligarchy controlled by the wealthiest citizens - but whose main tactic is to rally the plebeians (the common people) through populist policies. The House's draft tax plan provides sweeping gains for the wealthiest. It also preserves or expands some benefits for the poorest groups, so as to make it politically achievable. The upper middle class - the professional class - stands to suffer the most under the new tax scheme. If this analysis is correct, what does it reveal about President Trump's strategy going forward? Anti-globalization rhetoric is just talk: The fourth round of NAFTA renegotiations ended with a bang: the U.S. delivered four new demands, two of which both Ottawa and Mexico City have identified as non-starters.9 However, in the pluto-populist scenario, even if NAFTA is ultimately abrogated, the Trump administration will ensure that the critical components are preserved in bilateral agreements with Canada and Mexico. While those agreements are negotiated, the Trump Administration will not raise tariffs to the maximum, "bounded," level as allowed by the WTO. Meanwhile, trade relations with China may still sour in 2018, but they will not produce a trade war. Social unrest could increase: As we argued in a recent Special Report, the American structural context is ripe for more social unrest due to "elite overproduction."10 Trump's policies are likely to feed this condition. Meanwhile, his rhetoric and symbolic gestures will fuel the flames of division in order to play to his base, and force Democrats to argue about how to respond. This would be the populist part of pluto-populism. Hawkish foreign policy: With most of his domestic policies stymied, President Trump will pivot to the foreign theatre. We would particularly watch the growing tensions in the Middle East between Saudi Arabia and Iran, which could soon involve Lebanon.11 President Trump has also decertified the Iran nuclear deal, setting the stage for Congress to decide whether it will impose new sanctions and thus abrogate the deal. Plus, there is always North Korea. Bottom Line: Essentially, President Trump's strategy will be to pass pro-business, pro-market economic policies while distracting his largely anti-business, anti-market voters through ancillary issues. Investment Implications On the one hand, this analysis implies a very bullish policy mix as the Trump administration will not do anything domestically that hurts the ongoing bull market. On the other hand, some of those "ancillary" issues could flare up and impact the market, particularly if they involve a ratcheting up of tensions with Iran and North Korea. Chart 6No Debate: There Is No##BR##Trickle-Down From Tax Cuts The one risk that we remain concerned about is protectionism. We expected Trump to be more disruptive this year, and the above analysis suggests that protectionism, too, is merely hot air. However, Trump has only been in office for ten months. The absence of trade tensions with China may be a function of ongoing negotiations with North Korea: the U.S. needs China's cooperation in order to force North Korean leader Kim Jong-Un to the table. Ironically, then, a resolution of North Korean tensions could increase America's maneuvering vis-à-vis China, allowing Trump to become a lot more protectionist in 2018.12 Moreover, investors may be overemphasizing headline trade negotiations such as NAFTA or the China talks. The Trump administration may pursue protectionist aims through selective tariffs, such as countervailing and anti-dumping duties, in selective fashion. In other words, investors should pay attention to individual tariff decisions rather than overall negotiations.13 As for his electoral base, as long as President Trump can continue to ensure that they are focused on social disputes at home and hawkish rhetoric abroad, they may not notice the lack of movement on domestic promises. In particular, we have a high-conviction view that the just-proposed tax cuts will do nothing to curb income inequality in the U.S., and will likely deepen it, as previous such GOP-efforts did (Chart 6). Will this hurt President Trump in his 2020 reelection bid? We doubt it. But it does portend still greater socio-economic tensions and political populism in the long run. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The promise was made in a Wall Street Journal opinion piece that then-candidate Trump penned on November 9, 2015. Please see Donald J. Trump, "Ending China's Currency Manipulation," dated November 9, 2015, available at wsj.com. 2 The top marginal tax rate of 39.6% is currently applied to single individuals making more than $418,401, a head of household making more than $444,501, and married couples, filing jointly, making more than $470,701. Technically, according to the current draft bill, the top tax rate in the House plan is supposedly about 45.6% between $1-$1.2 million, after which it falls back to 39.6%. A quirk in the proposal holds that once a filer hits $1 million of income, the IRS starts clawing back the $12,000 that the filer saved from having a 12% tax rate on his first $90,000 of income instead of a 25% tax rate. That clawback comes in the form of 6% surtax on income above $1 million. The $12,000 is completely reclaimed once the filer hits $1.2 million. By extension, everyone who makes over $1.2 million has had to pay that extra $12,000 in taxes. 3 For more on how the reconciliation process works, and how it will affect the timeline, please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 From a political perspective, the GOP may have simply made a bet that high-tax-rate, blue-state households making $260,000-to-$430,000 do not vote Republican. 5 The congressional budget resolution that sets out the reconciliation instructions for these tax cuts also includes draconian spending cuts, which would presumably help balance the books. Although none of those cuts will pass Congress, they reveal the traditional preference of the Republican party: cut taxes, pay for the cuts by means of a smaller government delivering fewer services. 6 And perhaps this investment boost will come just in time to help re-elect Trump in 2020! 7 Although he deserves some credit for bringing to conclusion the pre-existing fight against the Islamic State. 8 In fact, the House tax bill leaves the "carried interest" tax break in the code. 9 For more on NAFTA, please see our upcoming Special Report with BCA's Global Investment Strategy, to be published on November 10. 10 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Lebanese Sunni Prime Minister Saad Harriri recently resigned while visiting Saudi Arabia, claiming that he feared for his life due to Iranian influence in Lebanon; Saudi Arabia itself is engaged in deep political struggle. 12 Indeed, in our original forecast of Trump's trade policy, we surmised that 2017 would largely be a year of negotiations, while 2018 would see the real fireworks. Please see BCA Geopolitical Strategy, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 13 An important such decision looms by January 12, 2018, which is the deadline by which President Trump must decide whether to impose "safeguard" tariffs on imports of solar panels and washing machines.
Neutral The news that talks between Sprint and T-Mobile over a possible merger had ceased has hurt the S&P telecom services index this week (top panel). The potential tie-up would have created a much stronger competitor to the AT&T/Verizon oligopoly in the mobile industry. This summer, when rumors of the merger were first circling, we posited that reducing competition at the low end of the market would be margin accretive, particularly as U.S. consumer spending on telecom services was surging (second panel); in that context, we upgraded the index to neutral. Spending has now fallen back into deflation as competition has intensified; earnings seem likely to suffer in the near term. Anecdotally, both T and VZ reported earnings contractions in Q3 despite solid subscriber growth, corroborating the deflationary price environment. However, the weak earnings outlook has been priced into the index, which is now trading at its cheapest level in more than a decade (bottom panel). Accordingly, our neutral thesis is dented, but not broken; we recommend staying on the sidelines to watch the industry shake out. The ticker symbols for the stocks in this index are: T, VZ, CTL. Telecoms Are Cheap For A Good Reason
Highlights Chart 1Fed Must Fall Behind The Curve Jerome Powell will assume the Fed Chairmanship at a critical juncture for monetary policy. Core PCE inflation is still well below the Fed's 2% target, and yet, the slope of the 2/10 Treasury curve is a mere 71 bps (Chart 1). Such a flat yield curve alongside such low inflation suggests that the market believes the Fed will tighten the yield curve into inversion before inflation even regains the Fed's target. That would be an unprecedented policy mistake that the new Chairman will seek to avoid at all costs. This means either inflation will soon rise, justifying the FOMC's median rate hike projections, or inflation will stay low and the Fed will be forced to take a dovish turn. Either way the Fed must "fall behind the curve" and start chasing inflation higher. The act of falling behind the inflation curve means that long-maturity TIPS breakevens are likely to widen, the yield curve will steepen and the policy back-drop will stay accommodative for spread product. We recommend positioning for all three of these outcomes. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in October, bringing year-to-date excess returns up to 288 bps. The average index option-adjusted spread tightened 6 bps on the month, and now sits at 97 bps. Two weeks ago we noted that there is simply not much room for investment grade corporate spreads to tighten.1 Looking at 12-month breakeven spreads shown as a percentile rank relative to history, we see that A-rated paper has only been more expensive than it is today 7% of the time. Baa-rated paper has been more expensive only 9% of the time (Chart 2).2 Further, we calculate that at current duration levels Baa-rated option-adjusted spreads can only tighten another 36 bps before the sector is more expensive than it has ever been. Similarly, A-rated spreads can tighten another 14 bps, Aa-rated spreads another 17 bps and Aaa-rated spreads another 7 bps. All this to say that corporate bonds are essentially a carry trade at this stage of the cycle. The important question is how much longer we can pick up the carry before a period of significant spread widening. With low inflation keeping monetary policy accommodative and accelerating profit growth putting downward pressure on leverage (bottom 2 panels), the carry trade appears safe for now (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3B Corporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 51 basis points in October, bringing year-to-date excess returns up to 580 bps. The index option-adjusted spread (OAS) tightened 9 bps on the month, and currently sits at 339 bps. Based on our current forecast for default losses we calculate that, if junk spreads remain flat, high-yield excess returns will be 230 bps for the next 12 months. If spreads tighten by 100 bps we should expect excess returns of 606 bps, and if spreads widen by 100 bps we should expect excess returns of -145 bps (Chart 3). Given that the OAS for the high-yield index can only tighten another 139 bps before it reaches all-time expensive valuations, 606 bps is a fairly optimistic excess return projection. But equally, with inflation pressures still muted and monetary policy still accommodative, more than 100 bps of spread widening is also unlikely. Our base case forecast is that high-yield excess returns will be between 2% and 5% (annualized) on a 6-12 month investment horizon.3 In a recent report we noted that high-yield generally looks more attractive than investment grade after adjusting for differences in spread volatility between the two sectors.4 Specifically, we calculate that it will take 39 days of average spread tightening before B-rated bonds reach all-time expensive levels. The same calculation shows it will take 19 days for A-rated debt. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in October, bringing year-to-date excess returns up to 31 bps. The conventional 30-year zero-volatility MBS spread was roughly flat on the month, as was the option-adjusted spread (OAS) and the compensation for prepayment risk (option cost). Last month we upgraded Agency MBS from underweight to neutral, noting that OAS have become significantly more attractive during the past year, particularly relative to corporate credit (Chart 4). The spread widening likely resulted from the market pricing-in the impact of the Fed's balance sheet run-off. Now that the run-off has begun, and its future pace has been well telegraphed, its impact has probably also been fully priced. While OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments, it is the change in the nominal spread that determines capital gains and losses. With that in mind, it is difficult to see a catalyst for significantly wider nominal MBS spreads on a 6-12 month horizon. The two factors that correlate most closely with nominal MBS spreads - credit spreads and mortgage refinancings - are likely to stay depressed (bottom panel). Higher mortgage rates would obviously prevent refinancings from rising. But we showed in a recent report that even if rates move lower the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.5 Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to 193 bps. Sovereign bonds underperformed the Treasury benchmark by 5 bps on the month. Foreign and Domestic Agency bonds outperformed by 2 bps and 9 bps, respectively. Supranationals outperformed by 4 bps. The underperformance in Sovereigns was concentrated in Mexican debt, which sold off as the White House took a hard line on NAFTA negotiations. Local Authority bonds outperformed by 62 bps in October, bringing year-to-date excess returns up to 367 bps (Chart 5). Excess returns for Local Authority debt - mostly taxable municipal debt and USD-denominated Canadian provincial debt - have exceeded excess returns from Baa-rated corporate debt so far this year, despite the sector's average credit rating of Aa3/A1. In a recent report we looked at whether USD-denominated Emerging Market Sovereign debt is an attractive alternative to U.S. high-yield corporates.6 We observed that hard currency EM sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year. Further, we observed that periods when EM Sovereigns outperform U.S. corporates tend to coincide with falling U.S. rate hike expectations, as measured by our 24-month fed funds discounter. At present, our 24-month discounter is at 74 bps, meaning the market expects less than three Fed hikes during the next two years. We anticipate a better opportunity to move into EM Sovereigns once U.S. rate hike expectations have adjusted higher. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in October (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 251 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged down in October and currently sits at 87%, still extremely tight relative to its post-crisis trading range. M/T yield ratios look much more attractive at the long-end of the curve (Chart 6), and we continue to recommend that investors extend maturity within their municipal bond allocations. Congress released its first draft of proposed tax legislation last week, and while it will certainly undergo some changes in the coming months, it appears as though it will not be very negative for municipal bondholders. Crucially, the top marginal personal tax rate remains unchanged at 39.6% and demand for munis should benefit from the removal of other deductions. A reduction of the corporate tax rate to 20% remains a risk, but that will likely be revised higher as the bill is re-written. Fundamentally, state & local government health improved sharply in Q3, with net borrowing likely falling to $157 billion from $211 billion in Q2, assuming that corporate tax revenues are unchanged (Chart 6).7 The rate of growth in state & local tax revenues now exceeds expenditures and that should put further downward pressure on borrowing in the coming quarters. However, a decline in state & local government borrowing is already reflected in historically tight M/T yield ratios. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in October alongside a sharp move higher in the expected pace of Fed rate hikes (Chart 7). The 2/10 Treasury slope flattened 8 bps and the 5/30 slope flattened 7 bps. The upward adjustment in rate hike expectations benefited our recommendation to short the July 2018 fed funds futures contract. That trade is now 13 bps in the money since it was initiated on July 10. Further, the July 2018 contract is still discounting fewer than two rate hikes between now and next July. If two more hikes are delivered by July our trade will earn an additional 5 bps. If three more hikes are delivered it will earn an additional 31 bps. In a recent report we discussed why the Fed must soon "fall behind the curve" on inflation and allow the yield curve to steepen.8 Essentially, unless the Fed starts to chase inflation higher it will soon invert the yield curve without having met its inflation goal. That would be a severe policy mistake. This means that either inflation must start to rise, or the Fed must slow its pace of rate hikes. Both scenarios lead to a steeper yield curve. We continue to position for a steeper curve via a long position in the 5-year bullet versus a short position in the 2/10 barbell. At the moment our model shows the 5-year bullet trading roughly in-line with its fair value, or alternatively that the 2/5/10 butterfly spread is priced for an unchanged 2/10 slope on a 6-month horizon.9 TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 33 basis points in October, bringing year-to-date excess returns up to -99 bps. The 10-year TIPS breakeven inflation rate rose 4 bps on the month but, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was pointed out on the front page of this report, the Fed must "fall behind the curve" on inflation if it wants to avoid a policy mistake. Our expectation is that this will occur because inflation will move higher in the coming months. The 6-month rate of change in trimmed mean PCE has already bounced off its lows (Chart 8) and pipeline measures of inflation are soaring (panels 3 & 4). However, even if inflation remains stubbornly low, we think any downside in long-maturity TIPS breakeven rates will prove fleeting. We are approaching an inflection point where if inflation does not rise the Fed will have to adopt a much more dovish policy stance. This should limit any downside in long-dated breakevens. As long as the Fed can maintain interest rates low enough for realized inflation to eventually recover to its target, then we anticipate that long-maturity TIPS breakeven rates will settle into a range between 2.4% and 2.5% by the time that occurs. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in October, bringing year-to-date excess returns up to 81 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to 71 bps. Non-Aaa ABS outperformed the benchmark by 32 bps, bringing year-to-date excess returns up to 176 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps in October and, at 33 bps, it remains well below its average pre-crisis trading range. We continue to favor credit cards over auto loans within Aaa-rated ABS, despite the modest additional spread pick-up available in autos (Chart 9). The main reason is that auto loan net losses have been trending steadily higher for several years while credit card charge-offs are still depressed (panel 4). However, even the credit card space is starting to see rising delinquency rates, albeit off a low base, and banks are tightening lending standards on both auto loans and cards (bottom panel). We expect that tight labor markets and solid income growth will prevent a surge in consumer delinquencies, but these are nonetheless troubling signals that bear monitoring. From a valuation perspective, with the 33 bps OAS offered from Aaa-rated Consumer ABS now only slightly higher than the 29 bps offered by Agency Residential MBS, we advocate a neutral allocation to consumer ABS. Further increases in delinquencies could warrant an eventual downgrade, stay tuned. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 71 basis points in October, bringing year-to-date excess returns up to 182 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS tightened sharply in October, from 74 bps to 65 bps. At current levels it is now one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in October, bringing year-to-date excess returns up to 96 bps. The index OAS for Agency CMBS tightened 6 bps on the month but, at 46 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 33 bps, and the OAS on conventional 30-year Agency MBS is a mere 29 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is probably worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.69% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.67%. The Global Manufacturing PMI increased to 53.5 in October, its highest level in six-and-a-half years. Bullish sentiment toward the dollar also edged higher, but not by enough to prevent the fair value reading from our 2-factor Treasury model from climbing. Last month's fair value reading was 2.65%. The U.S. and Eurozone PMIs continued to trend up, while the Chinese PMI held flat. The Japanese PMI ticked down from 52.9 to 52.8. Most importantly, of the 36 countries we track 34 now have PMIs above the 50 boom/bust line. The global economic recovery has become incredibly broad based, a bearish development for U.S. Treasury yields. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 2 We use breakeven spreads to adjust for the changing duration of the index over time. We calculate the 12-month breakeven spread as option-adjusted spread divided by duration. We ignore the impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 9 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. We cited a soft U.S. dollar, firming demand, constrained supply growth and still-compelling valuations as reasons to go overweight; these have started to move in our favor, signaling more upside ahead. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (second panel). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, the rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher (third panel). Valuations have ticked up recently but on a price to book and price to sales basis, energy stocks still sport compelling multiples (bottom panel). Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Please see yesterday's Weekly Report for more details. Content
Highlights Powell's nomination will not change the Fed's gradual rate hike path, but open Board seats are a worry. Household debt growth is slower than usual, but auto debt levels are a concern. Stocks will beat bonds and oil will rise after EPS growth peaks next year. Funding liquidity should remain adequate as the Fed unwinds its balance sheet. Feature Last week was an extraordinarily busy week for U.S. financial markets, but BCA's view on the economy, the Fed and asset class returns remains the same. President Trump named Jerome Powell to replace Janet Yellen as Fed Chair and the GOP released additional details of their tax plan. The October readings on employment, manufacturing, and wage growth fell short of expectations. However, data on consumer confidence, non-manufacturing ISM and vehicle sales for October exceeded expectations. The Q3 Employment Cost Index will give Fed policymakers confidence that the Phillips curve is not dead, but the persistent weakness in unit labor costs (the Q3 data was released last week) will concern the FOMC. The Fed remains on track to raise rates by 0.25% in December and three more times in 2018, matching their dot plot. While average hourly earnings disappointed in October, the impacts of Hurricanes Harvey and Irma make the data difficult to interpret. Nonetheless, the year-over-year growth in the 3-month moving average of average hourly earnings was 2.6% in October, up from 2.5% in July, before Harvey made landfall in Texas. Moreover, real GDP is growing faster than the economy's long term potential (1.8% per the Fed), and at 4.1%, the unemployment rate is well below the Fed's measure of full employment (4.6%) (Chart 1). Jerome Powell will continue to pursue the gradual rate hikes preferred by his predecessor. However, Powell is the first Fed Chair since G. William Miller (1978-79) to not have a PhD in economics. He is not known as a policy hawk or a dove, and this lack of conviction in his own policy suggests that he will rely on more on his Board colleagues for direction than recent chairs. The potential power shift from the chair to the committee may make FOMC communications more difficult to interpret. After Yellen departs the Fed early next year, the seven-member board will be down to just four, providing Trump the opportunity to further shape monetary policy. Table 1 provides Powell's comments on key aspects of the economy, monetary and regulatory policy. Chart 1Labor Market Conditions Tightening##BR##And Support More Rate Hikes Table 1Powell On Monetary Policy, The Economy And Regulation BCA expects that Powell, a Republican, will be confirmed by the Senate and preside over the FOMC meeting in March 2018. Powell already sits on the Fed Board. In 2012 President Obama appointed Powell to the Fed to fill an unexpired term. The Senate voted 74-21 to confirm. Two years later, Powell was confirmed 67-21 for a full term (14 years) as a governor. Fifty-one votes are required for confirmation. BCA's Chief Economist, Martin Barnes, wrote about the potential for change at Federal Reserve Board earlier this year.1 The bottom line is that looming changes in the composition of the Fed's Board of Governors are important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Subprime Auto Sector Signals Household deleveraging has ended, but consumers are reticent to take on new debt despite an improving labor market and record household net worth. Household debt is growing at under 2% a year, less than half the pre-crisis pace. Moreover, household debt relative to disposable income remains well below a decade ago, but the household indebtedness profile is not uniform. While the debt-to-disposable income ratio of mortgage and revolving consumer credit has moved lower, the ratio of non-revolving credit (which includes both auto and student loan debt) has moved up since 2010 and surpassed the 15.8% pre-crisis peak in 2012 (Chart 2). Chart 2Household Debt By Sector In 2016, 34% of U.S. families had vehicle loans, up from a low of 30% in 2010. In 2004-2007, more than one-third of U.S. families carried auto debt (Chart 3). The median value of households' auto loans is $13,000 (in 2016 dollars), up from $11,000 in 2010, but still below the 2004-2007 peak of $14,000 (Chart 4). However, delinquency rates are on the rise in those areas where consumers have been adding debt (credit cards, auto loans and student loans) (Chart 5). Chart 3Rise In % Of Families With Auto Loan Debt... Chart 4...But Auto Debt Levels Are Manageable In particular, default rates in auto and student loans are above their mid-2000s readings, but are below their 2010-2012 zenith. Lending standards for vehicle loans were easy at the start of the decade, became less so recently and then turned restrictive in mid-2016. In the mid-2000s, borrowing guidelines for student loans and credit cards (data on bank lending standards for auto loans began in 2011) were easy in 2004-2007. Banks are taking a cautious approach to consumer lending in this cycle. The gradual tightening of lending criteria between 2010 and 2016 led to a drop in the average FICO score for new auto loans. However, as standards tightened in 2016 and into the first quarter of 2017, the average FICO escalated. FICO scores for new vehicle loans moved sharply lower in Q2; it may be a new trend or perhaps a blip in the data. Even with the latest dip, the FICO for new auto loans (698) is well above the 675-685 range that prevailed in 2004-2006 (Chart 6, bottom panel). Chart 5Consumer Loan Metrics Chart 6ABS Market Overview Subprime auto loans as a percentage of all auto loans remain well below pre-crisis levels and should limit a wave of subprime auto defaults in the years ahead. Only 22% of the $148 billion in new vehicle loans recorded in Q2 2017 were issued to borrowers with FICO scores below 620. The latest reading is in the middle of the range that has been in effect since 2010 (18-25%). Between 2004 and 2007, the share of auto loans issued to subprime borrowers was as high as 32% in 2006 and averaged 28%. The FOMC has elevated financial stability in its recent deliberations2 and is watching for imbalances. The September 20-21 FOMC meeting minutes noted that "Subprime auto loan balances have declined so far this year, partly reflecting the tighter lending standards, and the average credit score of all borrowers who obtained an auto loan in the second quarter remained near the upper end of its range of the past few years." We expect the Fed to remain vigilant on this issue. Bottom Line: Household debt ratios are well below the pre-2007 peak, but consumers are piling on more auto debt. While delinquency rates for auto debt are rising, banks are tightening lending requirements and have not extended auto credit to subprime borrowers outside of historical norms. If household incomes, the stock market and housing prices rise, and banks and regulators remain vigilant, then the subprime auto sector would not pose a systemic risk to the U.S. economy or financial system.3 BCA's U.S. Bond Strategy service prefers Aaa-rated credit card ABS over Aaa-rated auto loan ABS (Chart 6). Investment Direction After EPS Peak Chart 7Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The BCA earnings model shows that S&P 500 EPS growth is peaking and should slow through 2018 toward a level commensurate with 3½-4% nominal GDP growth (Chart 7). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller force. This forecast excludes any positive effects on growth from tax cuts that would encourage EPS and the S&P 500 index in the short term, although this would also bring forward Fed rate hikes. We will provide an update on the Q3 earnings reporting season in next week's report. Investors are questioning what will happen to risk assets after earnings growth peaks, but before it slips below zero (Table 2). BCA has identified seven episodes between 1973 and 2015 when S&P 500 EPS growth reached a top and subsequently dipped below zero. Four of the seven periods (1973-75, 1976-80, 1988-1991, and 1993-2001) partially overlapped with recessions. The U.S. economy was in recession during the entire 1973-75 period but the recession occurred at or near the end in the other three occurrences. U.S. stocks, Treasuries and oil behave consistently during these periods. The performance of gold, the dollar, small caps (relative to large) and high yield (relative to Treasuries) is not consistent, and investment-grade corporate debt underperformed Treasuries in six of the seven intervals. On average, stocks beat bonds by 3,000 bps after earnings decelerate, but before they turn negative. Oil (+8,310 basis points) and gold (+6,950 bps) are the standouts; both commodities beat stocks) as earnings growth fades. Small caps barely outperform large, and the dollar, on average, is flat across all seven periods. Investment-grade corporate debt underperforms Treasuries by an average of 50 bps during these episodes. Table 2U.S. Asset Class Performance As EPS Growth Slows The three occasions when EPS growth crested and then slowed to zero, but the economy avoided a recession, were in the mid-1980s, the mid-2000s and the early part of the current decade. These mid-cycle slowdowns were triggered by Fed rate hikes in the mid-1990s and mid-2000s; in the early 2010s, there were similar fears of a rate increase, coupled with a stronger dollar and a collapse in oil prices. The performance of risk assets during these mid-cycle earnings corrections was similar to the entire sample, although the magnitude of the asset class performances shifted. Oil (+12,560 bps) and gold (+8,400 bps) were standouts; equity and Treasury prices both rose, but equities beat Treasuries by nearly 10,000 bps, easily surpassing the 3,000 bps outperformance in all periods. Small caps underperformed large caps and the dollar climbed (Chart 8). Chart 8U.S. Asset Class Performance As EPS Growth Slows Bottom Line: S&P 500 earnings growth will peak in 2018. Stocks will outperform bonds as profit growth slows, which matches BCA's stance for the next 12 months. Gold and oil have both outpaced equities as earnings abate; this supports BCA's bullish position and above-consensus view of oil for 2018. BCA's modestly bullish stance on the dollar in the next 12-18 months aligns with the historical achievements of the dollar as earnings moderate, but BCA's bullish view on small caps runs counter to history after EPS growth crests. The Great Balance Sheet Unwind Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart 9 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. In an October 2017 Special Report,4 the Bank Credit Analyst outlines how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. Chart 10 presents our forecast for how quickly the Fed's balance sheet will contract. Following the September 19-20 FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Chart 9G4 Central Bank Balance Sheets Chart 10Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.5 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario, the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. The bond market's reaction will be far more important than balance sheet shrinkage. Empirical estimates suggest that the Fed's shedding of Treasuries could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio; As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. However, it will be a whole different story if inflation lurches higher. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Should You Fear Looming Changes At The Federal Reserve?", September 21, 2017. Available at bca.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade," October 3, 2017. Available at usbs.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Liquidity And The Great Balance Sheet Unwind," In the October Monthly Report. Available at bca.bcaresearch.com. 5 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017).
Highlights Portfolio Strategy Rising oil prices, a weakened U.S. dollar, ongoing global oil producer discipline and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Wide crack spreads, sticky price hikes and sustained inventory drawdowns are a harbinger of more gains in the S&P refiners sub-index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities plowed higher last week, as earnings growth continues to surprise to the upside and synchronized global growth alongside fiscal easing remain the key macro themes. Over 81% of the companies have now reported earnings, with EPS growth pushing the Q3 blended figure to 8.0% on the back of 5.2% revenue growth. Last quarter's margin expansion is in line with the S&P 500's historical operating leverage of 40%.1 In the context of synchronized global growth macro backdrop, we have been adding deep cyclical exposure to our portfolio at the expense of defensives over the past few months, participating in the SPX's march higher. A simple manufacturing versus services indicator, comparing ISM manufacturing with ISM non-manufacturing, suggests that not only are there more gains ahead for the broad market, but cyclicals will also continue to outpace defensives (Chart 1). When the most cyclical part of the U.S. economy is flexing its muscle, typically a capex upcycle sustains the self-reinforcing earning upsurge. In mid-October2 we posited that such an investment boom will be the dominant macro theme next year. While this theme continues to fly under the radar, our confidence of a durable and broad-based capital spending cycle notched higher following the recent Q3 real GDP print. Table 2 shows the evolution of real GDP, real capex growth and real capex contribution to real GDP growth over the last year. CEOs are voting with their feet and making the longer-term oriented investment decisions as animal spirits are lifting, despite a very slow moving Washington, D.C. Chart 1Most Cyclical Part Of##br## U.S. Economy Is Flexing Its Muscle Table 2Evolution Of GDP ##br##And Capex Growth Chart 2 depicts these data on a longer time horizon. There are high odds that capital outlays will remain upbeat if BCA's view of a tax bill passage materializes3 in the next 6 months with some of the money making its way toward investment, sustaining the virtuous cycle. Were the GOP's tax plan to pass and allow businesses "to immediately write off the full cost of new equipment", then almost certainly CEOs will embark on a capex binge. Importantly, similarly to the synchronized global growth macro backdrop, there is a synchronous capex upcycle brewing. The top panel of Chart 3 shows our equal-weighted real gross fixed capital formation composite of 23 DM and EM countries using national accounts alongside our diffusion index. Our Global Capex Composite has stabilized, but more importantly the diffusion index (percentage of countries with an improving year-over-year capex) is showcasing a coordinated global capex recovery. Chart 2Capex... Chart 3...Is Growing Globally True, DM capex is more advanced than EM capex, but the V-shaped recovery in corporate profitability nearly guarantees a pickup in capital outlays in the coming quarters (middle and bottom panel, Chart 3). Another way we show this simultaneous global capex upcycle is the color coded map in Table 3, with green denoting an expansion in year-over-year real capex, and red a contraction. Green is taking over the table (please click here if you would like to receive this table with more details from our client services department). Table 3Synchronized Global Capex Growth Encouragingly, this is not only a national accounts reported capex phenomenon, but is also borne out by stock market reported data. Using Datastream-compiled stock market reported data, Charts 4, 5, & 6 show capital expenditures growth around the globe covering a number of DM and EM. Similar to our mid-October analysis, we advance operating earnings by one year, and investment should follow profit growth higher in the coming quarters underpinning the virtuous cycle. Chart 4Virtuous... Chart 5...Global Capex... Chart 6...Upcycle The implication of this synchronous capex growth backdrop is that high operating leverage deep cyclicals will dominate defensives next year and we reiterate our recent preference of cyclical versus defensive sectors. This week we update a deep cyclical sector we continue to overweight, and highlight one niche subcomponent. A Burst Of Energy? We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. While this was a timely upgrade, we still believe there is more room for additional relative gains in the coming months. All the reasons we cited during our summer upgrade call4 have started to move in our favor, signaling more upside ahead. Namely, the U.S. dollar remains down significantly for the year (Chart 7) and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (Chart 8). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. Chart 7Weakened U.S. Dollar Is Bullish Energy Chart 8Catch Up Phase On the supply front, both the overall U.S. oil & gas and horizontal only rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. As global oil inventories get whittled down and OPEC stays disciplined oil prices will remain well bid. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher. The implication is that the relative share price advance is still in the early innings (Chart 9). Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. On a price to book, prices to sales and price to cash flow basis energy is trading at a 40%, 30% and 5% discount, respectively, to the broad market. The recent carnage in EPS skews the results with the energy sector trading at a 47% forward P/E premium to the overall market (Chart 10). Our Technical Indicator has also tentatively troughed. Historically once the one standard deviation below the historical mean level gives way, a sling shot recovery ensues (Chart 10). Finally, the budding recovery in energy earnings remains intact and our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline (Chart 11). Chart 9Oil Inventory Drawdown = Buy Energy Stocks Chart 10Compelling Valuation Backdrop Chart 11EPS Model Is Still Flashing Green Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintain an above benchmark allocation in the S&P energy index. Bottom Line: We reiterate our early-July S&P energy sector upgrade to overweight. Refiners Are Heating Up In the summer we lifted the S&P oil & gas refining & marking index to neutral from underweight locking in impressive gains and that tilted our overall S&P energy sector exposure to above benchmark.5 Subsequently in early-September we further augmented exposure in this pure play energy downstream index to overweight.6 Since then, relative performance is up over 8%. Is it time to book profits? The short answer is not yet. While these relative gains are impressive in such a short time span, we are staying patient before monetizing them, as leading indicators of refiners' profits continue to flash green. Our thesis in September was that the Hurricane Harvey catastrophe presented a trading opportunity from the long side for the S&P refining index. Not only did production get substantially curtailed, but also, as a result, inventories gave way. The longer the disruption, the sweeter the profit spot for the refining industry, as only higher industry selling prices could bring the market back to equilibrium. Indeed, the Brent/WTI crude oil spread, a great proxy for refining margins, recently vaulted to $8/bbl, the highest since early-2015 (Chart 12). Refining margins and gasoline prices also jumped to multi-year highs. While the industry has recovered since the hurricane devastation and brought production back online, selling price inflation is proving sticky, which is a boon for industry margins and thus profits. Already, this earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (Chart 13). Looking closer at the inventory backdrop, the refined product drawdown is ongoing. From the early 2017 peak, gasoline and distillate fuel supplies have collapsed by roughly 100mn bbl (inventories shown inverted, top panel, Chart 13). In particular, gasoline stocks are now contracting at 5% per annum (inventories shown inverted, middle panel, Chart 13). Historically, industry inventory accumulation has been weighing on relative share prices and vice versa. Evidently, the market has yet to reach an equilibrium, which is a boon for refining profits and relative share prices. Finally, following the collapse in refined product net exports as refiners focused on primarily fulfilling domestic demand, net exports have jumped back to all-time highs near 3mn bbl/day. This represents an over 6mn bbl/day swing in net exports over the past decade (bottom panel, Chart 14). A weak U.S. currency coupled with the higher prices oil products fetch abroad should continue to underpin exports and represent another sizable avenue for industry profits. Chart 12Too Early To##br## Lock In Profits Chart 13Decreasing Refined Product ##br##Stocks Are A Boon For Refiners Chart 14Export Relief ##br##Valve Reopened Netting it out, it is still too soon to take profits on the S&P oil & gas refining & marketing index. Refined product inventories continue to fall, crack spreads are wide and industry price hikes are sticky. This is a fertile profit margin and EPS backdrop, underscoring that the path of least resistance is higher for relative share price, at least until an equilibrium is reached. Bottom Line: Stay overweight the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," dated April 17, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 5 Ibid. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Still Goldilocks," dated September 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Jerome Powell takes the helm of the Federal Reserve at a time when both sides of the Fed's dual mandate are in conflict. The lagging nature of inflation explains why it has failed to rise even though the unemployment rate has fallen below NAIRU. U.S. growth should surprise on the upside over the coming quarters, with or without the passage of tax legislation. This should enable the Fed to raise rates four times by end-2018, which should give the dollar a boost. Higher oil prices will prop up the Canadian dollar. Brexit uncertainty will continue to weigh on the U.K. economy, but the pound has already priced in much of the bad news. Feature Chart 1The Dual Mandate Headache Jay Powell: You're Hired! Jerome Powell takes the helm of the Federal Reserve at a pivotal time. Under Janet Yellen's leadership, the Fed began running down its balance sheet. For all intents and purposes, that part of the normalization process has been put on autopilot. In contrast, the question of how much higher interest rates need to go remains up in the air. In normal times, the Fed would be guided by its dual mandate, which calls for maximum sustainable employment and low inflation. The Fed's predicament is that the two sides of this mandate are currently in conflict: While the unemployment rate has fallen more than the FOMC anticipated at the start of the year and is below the Fed's estimate of full employment, inflation has dipped further below the Fed's 2% target (Chart 1). Why Has Inflation Been So Low? There are four competing explanations for why inflation remains stubbornly low. The first is that the headline unemployment rate understates the true amount of labor market slack. There was considerable merit to this argument a few years ago, but it seems less plausible today. While some auxiliary measures of slack, such as involuntary part-time employment and the share of the working-age population that is out of the labor force but wants a job, are still elevated relative to pre-recession levels, others such as the job openings rate and household perceptions of job availability have reached levels consistent with an overheated economy (Table 1). Taken together, the U.S. labor market appears to be close to full employment. Table 1Comparing Current Labor Market Slack With Past Cycles The second explanation for why higher inflation has failed to materialize accepts the centrality of the unemployment rate as an accurate summary measure of labor market slack, but posits that NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - is lower than widely believed. NAIRU cannot be observed directly, so in principal this argument could be true. That said, it is worth noting that official estimates of NAIRU are already well below their long-term average (Chart 2). While certain factors such as the aging of the workforce have reduced NAIRU - older people tend to change jobs less frequently, which reduces frictional unemployment - other factors have likely raised it. These include automation, globalization, and the opioid crisis, all of which have probably led to higher structural unemployment. The third explanation for why inflation has failed to rise in the face of falling unemployment is that the Phillips curve has broken down. Whether they realize it or not, people who make this argument are implicitly assuming that NAIRU no longer matters - that central banks can drive the unemployment rate down as far as they wish and not worry about runaway inflation. If true, this would seemingly revoke the law of supply and demand because it would imply that an economy can stay perpetually overheated without wages or prices ever having to rise. Alas, no such free lunch exists. Chart 3 shows that the relationship between wage growth and unemployment remains intact. The so-called "wage-Phillips curve" tends to steepen sharply once unemployment falls below 5%. The recent acceleration in average hourly wages, median weekly earnings, and the Employment Cost Index all suggest that we have reached the steep part of the Phillips curve (Chart 4). Chart 2NAIRU Estimates Are Historically Low Chart 3U.S. Economy Has Moved Into ##br##The 'Steep' Part Of The Phillips Curve Chart 4U.S. Wage Growth Is Accelerating Higher wage growth will push up real household disposable income, leading to more consumer spending. With the output gap now effectively closed, firms will find themselves running into more supply-side constraints, forcing them to raise prices. Just as in the past, "this time is different" explanations for why inflation will stay depressed, such as the overhyped "Amazon effect," will be proven wrong.1 This leads us to the fourth - and in our view, most cogent - explanation for why inflation has been low, which is that the Phillips curve has simply been dormant. History suggests that inflation is a highly lagging indicator (Chart 5). A variety of technical factors - ranging from a steep drop in cell phone data charges to a dip in prescription drug prices - have depressed inflation this year. As these wear off, inflation will slowly pick up. The recent increase in the ISM prices-paid component, along with producer price indices around the world, suggest that both domestic and external inflationary pressures are intensifying. Consistent with this, the NY Fed's "underlying inflation gauge" has reached an 11-year high of 2.8% (Chart 6). Chart 5Inflation Is A Lagging Indicator Chart 6Fed Sees Underlying Inflation Gathering Steam The Cost Of Waiting Admittedly, there is a lot of uncertainty about the degree to which inflation will accelerate over the next few years. With that in mind, many commentators have argued for a go-slow approach. "Wait to see the whites of inflation's eyes" as Larry Summers has colorfully stated. This perspective is not unreasonable, but we think most FOMC members will ultimately reject it. This is mainly because inflation is a highly lagging indicator. By the time it is obvious that inflation is getting out of hand, it is often too late to react. The unemployment rate is already half a percentage point below the Fed's estimate of NAIRU. If the labor market continues to firm up, the Fed will eventually have no choice but to tighten monetary policy by enough to bring the unemployment rate back up to NAIRU. This means that rates may have to rise above their neutral level for a considerable period of time. Such an outcome could lead to a significant re-rating of risk asset prices. It would also damage the economy. The U.S. has never avoided a recession in the post-war period whenever the three-month average level of the unemployment rate has risen by more than 0.3 percentage points (Chart 7). Chart 7What Goes Down Must Come Up? Already Behind The Curve The Fed has arguably already fallen behind the curve in normalizing monetary policy. As our models predicted, the easing in U.S. financial conditions earlier this year is helping to turbocharge growth (Chart 8). Real GDP rose by 3.0% in the third quarter. Growth would have been even higher had residential investment not fallen by 6% in the wake of the hurricanes. The Atlanta Fed's GDPNow model is pointing to growth of 4.5% in Q4. Chart 8U.S.: Easier Financial Conditions Are Boosting Growth Core capital goods orders are increasing at a solid pace. The Conference Board's index of consumer confidence rose to a 17-year high in October. Initial jobless claims have fallen to a four-decade low. Citi's economic surprise index has spiked into positive territory and Goldman's is nearing record highs (Chart 9). Given the recent acceleration in growth, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's current end-2018 projection of 4.1%. If Congress delivers on its pledge to reduce corporate and personal income taxes, this would represent a further modest upward surprise to near-term growth prospects. Fiscal policy remains a wildcard. The "Tax Cut and Jobs Act" released by the House of Representatives yesterday seeks to reduce taxes by about $1.5 trillion over the next ten years, with two-thirds of that amount consisting of lower business taxes (Table 2). Negotiations with the Senate are likely to result in a scaling back of the magnitude of the cuts and a shifting of more of the benefits towards middle-class earners. Among other things, this probably means the proposed phase-out of the estate tax will be scrapped. Most empirical estimates suggest that the growth benefits from the legislation will be modest. Nevertheless, if taxes are cut early next year, as we think is likely, this will put a greater impetus for the Fed to raise rates. Chart 9U.S. Economy Surprising On The Upside Table 2U.S.: How Much Will The Tax Plan Cost? Aging Bull Stocks are likely to weather the impact of Fed hikes as long as rates are rising in an environment of stronger GDP growth. Chart 10 shows that equities tend to do well when the ISM manufacturing index is elevated. This leads us to think the cyclical bull market in stocks will continue for the next 12 months. Chart 10Stocks Fare Well When The ISM Is Strong Once inflation begins to rise in earnest in 2019, equities will buckle. Given that the United States accounts for over half of global stock market capitalization, a selloff in the U.S. will be quickly transmitted to the rest of the world. Short-term oriented investors should remain overweight global equities for now, but look to turn more defensive late next year. Long-term investors should consider paring back exposure already. U.S. Dollar: Stronger For Now, Weaker in 2019 Once the U.S. falls into a recession in late 2019 and the Fed starts cutting rates, the dollar will crumble. But until then, the odds are that the greenback strengthens. Our model suggests that the dollar is undervalued against the euro based on today's level of spreads (Chart 11). Hence, even if spreads remain unchanged, we would expect the dollar to strengthen somewhat. Keep in mind that 10-year German bunds yield nearly two percentage points less than U.S. Treasurys. The euro would have to strengthen to 1.42 against the dollar over the next ten years just to compensate for the lower interest rates that bunds offer. Granted, if spreads between Treasurys and bunds were to narrow significantly, the euro would appreciate. Such an outcome is probable in 2019, by which time investors will begin fretting about a looming U.S. recession and pricing in Fed rate cuts. However, it is not likely to occur over the next 12 months, given the prospect that U.S. growth will accelerate over this period. Chart 12 shows the market's expectation of where one-month OIS rates will be in the U.S. and euro area over the next ten years. The one-month transatlantic rate spread currently stands at 151 basis points and is expected to peak in February 2019 at 210 basis points. It then declines gradually, falling to 164 basis points in five years and 107 basis points in ten years. Chart 11Dollar Is Undervalued Based On Current Spreads Chart 12Rates Will Diverge More In 2018 Than Is Priced In Relative to current market expectations, the interest rate spread one-year out is likely to widen further over the coming months. The market is currently pricing in 54 basis points of Fed rate hikes between now and end-2018, well below the "dot" forecast of 100 basis points. For his part, Mario Draghi made it clear last week that the ECB's bond buying program will continue until September 2018, and that the central bank will not raise rates until "well past the horizon of our asset purchases." Chart 13The Euro Has Overshot Interest Rate Spreads There is less scope for spreads to widen if one looks at expected interest rates more than one year into the future. However, we don't see much room for spread compression in the near term, so long as U.S. growth continues to surprise on the upside. Long-term inflation expectations are about 55 basis points lower in the euro area than they are in the U.S. As such, the expected spread in real short-term rates ten years out stands at about 50 basis points (Chart 13). This is not much different from Laubach and Williams' estimate of the gap in the real neutral rate between the U.S. and the euro area. Moreover, as we noted two weeks ago, the actual gap in expected interest rates should be larger than what is implied by neutral rate estimates since unemployment is likely to be above NAIRU more often in the euro area than in the United States.2 On balance, we remain comfortable with our year-end target for EUR/USD of 1.15 and see further upside for the dollar against the euro in 2018. Bank Of Japan: Nowhere Near The Exit Door The yen should also continue to trade down against the greenback. Governor Kuroda dismissed speculation that the BoJ is considering dialing back monetary accommodation during his press conference following this week's Monetary Policy Meeting. The BoJ lowered its inflation outlook for both FY2017 and FY2018, but maintained its projection of reaching its 2% inflation target in FY2019. In perhaps a sign of the times, newly selected board member Goushi Kataoka cast a dissenting vote, arguing that monetary policy should be even more accommodative. Kataoka suggested that the BoJ consider extending its yield curve targeting regime to government bonds with maturities of up to 15 years. Currently, the government seeks to cap yields for maturities of up to ten years. As bond yields elsewhere in the world drift higher, JGBs will become increasingly unattractive. This will weigh on the yen. CAD: Fade The Recent Weakness The Canadian dollar has been on the back foot lately. Last week Governor Poloz mentioned that "a lot of things have to come together" for the Bank of Canada to raise rates in December. This week brought news that the economy shrank by 0.1% in August due to a decline in manufacturing output. The market has gone from fully pricing in a hike in December to only assigning a one-in-five chance that rates will rise. Worries that the Trump administration will pull out of NAFTA have also weighed on rate expectations. Still, one should keep things in perspective. Real GDP is up 3.5% year-over-year - well in excess of the BoC's estimate of trend growth - while the output gap has been fully closed. Canadian GDP growth has historically been closely correlated with U.S. growth, so it would be very surprising if Canada's economy were to flounder just as America's is gaining steam (Chart 14). Chart 14Canada Remains Linked To The U.S. Canadian And U.S. Growth Are Correlated Chart 15The Pound Is Cheap And while the risk of a NAFTA pullout is real, most of Trump's wrath has been focused on Mexico. If NAFTA were to fall apart, Canada would still be covered by preexisting Canada-U.S. trade agreements. We will discuss this and other trade-related issues in a Special Report to be published next week. Perhaps most critically for the loonie, crude prices remain in an uptrend. BCA's energy strategists now see Brent averaging $65.2/bbl and WTI averaging $62.9/bbl in 2018, which is $6.2/bbl and $8.9/bbl, respectively, above current market expectations. Stick with it. Bank Of England Delivers A Dovish Hike In a split 7-to-2 decision, the Bank of England's Monetary Policy Committee voted to raise rates by 25 basis points for the first time in ten years yesterday. In a nod to the concerns that some board members had about raising rates, the MPC noted that "any future increases in the Bank Rate would be expected to be at a gradual pace and to a limited extent." The Committee also removed language suggesting that future rate hikes would have to be in excess of what the market has been pricing in. The MPC's reluctance to sound hawkish is understandable. While the unemployment rate has fallen to a four-decade low, growth has lagged behind the rest of Europe. Consumer confidence has weakened and the CBI retailers survey suggests that British households are tightening their purse strings. House prices in London have fallen 7% since the U.K. government started the formal process of Brexit seven months ago. Inflation is running at 3%, but this mainly reflects the lagged effects from the depreciation in the currency. Still, with the market pricing in only two additional hikes through to mid-2020, it is doubtful that rate expectations will fall much from current levels. There is also a reasonably high probability that Brexit will not occur. At some point over the next few years, the U.K. government will call a new referendum to affirm whatever deal it reaches with the EU. Given that the contours of the deal will be less favorable than what many pro-Brexit voters had been promised, it is likely that a majority of the populace will decide that life inside the EU is better after all. As such, the odds are good that the pound - which is very cheap based on our valuation measures - will strengthen over the long haul (Chart 15). Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017 and Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Weekly Report, "China, The Fed, And The Transatlantic Interest Rate Spread," dated October 20, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
The biotech complex has had a tough earnings season, having given up almost all of the gains made earlier this year as companies warned that intensifying competition would hurt top line growth. This corresponds with pharma pricing power hitting a five-year low, typically a strong predictor of the index's top line growth prospects (second panel). Tack on a tougher government-related pricing stance and a margin squeeze is likely. There is a bull case to be made that bad news in the biotech square has largely been priced in to the index, which has seen significant compression since the heady heights of 2013-14 (third panel). We disagree; relative to its growth prospects, and compared with the broad market, the S&P biotech index valuation has spiked well above normal levels. This leaves room for further margin compression as investors digest the bleak outlook. Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX-AMGN, ABBV, GILD, CELG, BIIB, REGN, ALXN, VRTX.