Economy
Highlights Currency markets continue to fight a tug of war between weak incoming data but easier financial conditions. Our thesis remains that the path of least resistance for the dollar is down, but the rising specter of global market volatility suggests it could catapult to new highs before ultimately reversing. Most of our pro-cyclical trades have been put offside in this environment of rising volatility. Maintain tight stops until more evidence emerges that global growth has bottomed. Large net short positioning in the Swiss franc and yen, together with cheap valuations, make them attractive from a contrarian standpoint. Hold on to CHF/NZD positions recommended on April 26. Feature Our thesis remains that global growth is in a volatile bottoming process. However, incoming data pretty much across the globe has been very weak, with the latest specter of a global trade war suggesting that economic softness could linger for longer than we originally anticipated. Given the shifting market dynamics, it is important to revisit our thesis on how to be positioned in currency markets. We do so this week via the lens of the Australian dollar, one of the market’s favorite short positions. Future reports will focus on additional global growth barometers, and when to time the shift towards a more pro-cyclical stance. Positive Divergences Chart I-1Global Growth Barometers Flashing Amber On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices are breaking down after a nascent upturn earlier this year. One of our favorite indicators on whether or not easing liquidity conditions will lead to higher growth are the CRB Raw Industrials index-to-gold, copper-to-gold, and oil-to-gold ratios. It is disconcerting that these indicators have moved decidedly lower together with U.S. bond yields, another global growth barometer (Chart I-1). On a similar note, currencies in emerging Asia that sit closer to the epicenter of Chinese stimulus are breaking down. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working. Not surprisingly, the Australian dollar has been breaking down at a rapid pace, putting our long AUD/USD position offside. We will respect our stop-loss at 0.68 if breached, but a few indicators suggest the bearish view on the Australian dollar is very late: Chart I-2Australian Stocks Hitting New Highs Election Results: The recent general election outcome was a big surprise to the market, and has eased risks to both the country’s banks and housing market. The center-left Labour party, which moved further to the left in this electoral cycle, was defeated by a substantial margin. This has a few important implications. First, “negative gearing” – the practice of using investment properties that are generating losses to offset one’s income tax bill – will remain in place. This was a big overhang on the housing market, which likely exacerbated the downturn in Aussie house prices. Second, the capital gains tax exemption from selling properties will probably not be reduced from 50% to 25%, as previously pledged. Finally, the Liberal-National coalition government will maintain the policy of reimbursing investors for corporate taxes paid by the underlying company. This keeps the incentive for retirees to own high dividend-yielding equities such as those of Australian banks. Australian equities hit a new cyclical high following the election results. This suggests the return on capital for Aussie companies may have inched higher following the more pro-market leadership shift (Chart I-2). At low levels of interest rates, fiscal policy is much more potent than monetary policy. Interest Rates: The latest Reserve Bank Of Australia (RBA) minutes suggest that rate cuts are back on the agenda. But the question is, with the markets pricing in two rate cuts by the end of this year, does it still pay to be short the Aussie dollar on widening interest rate differentials? More importantly, fiscal policy is set to become decisively loose this year. The new government is slated to introduce income tax cuts as early as July. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Meanwhile, infrastructure spending will remain high, which will be very stimulative for growth in the short term. At low levels of interest rates, fiscal policy is much more potent than monetary policy, and the RBA will be loath to cut rates more than is currently expected by the market, at a time when consumer indebtedness remains quite high, and policy rates are already close to rock-bottom levels. The key for the RBA will be the job market, which at the moment remains a pillar of support for the Aussie economy. Job growth is accelerating, and labor force participation is hitting fresh highs (Chart I-3). So long as these trends continue, the RBA can afford to remain on the sidelines for a while longer. Meanwhile, while Aussie rates continue to drift downward, it has not been particularly profitable to buy U.S. Treasurys on a hedged basis (Chart I-4). Chart I-3Australia Employment Remains Robust Chart I-4It is Expensive To Short The Aussie Housing Market: For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities has rapidly morphed into a housing crash (Chart I-5). This is negative for consumption, both via the wealth effect and as well as for the outlook for residential construction activity. Chart I-5Could Australian Housing Bottom Soon? The good news is that policy is supposed to become supportive for Aussie homebuyers at the margin, with the government slated to introduce new initiatives to help first-time homebuyers. Should labor market improvements continue, it will also help household income levels. Over the past few decades, house prices in Australia have generally staged V-shaped recoveries when at this level of contraction. Betting on at least some stabilization going forward seems reasonable. Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. Admittedly, most measures of Chinese (and global) growth remain weak. However, there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these advance any further, they will begin to exceed GDP growth, indicating a renewed mini-cycle (Chart I-6). Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-7). Given that the reduction – if not the outright elimination – of pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost. Chart I-6Some Green Shoots From China Chart I-7Australian LNG Will Buffet Terms Of Trade Valuation: In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 15% from its 2018 peak, and 38% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-8). One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-9). Chart I-8Short AUD: ##br##A Consensus Trade Chart I-9AUD Is Attractive From A Terms Of Trade Perspective China Credit Cycle: We have discussed at length how a revival in the Chinese credit cycle will help global and Australian growth. On the real estate front, residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signaling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales have usually been in sync across city tiers. A revival in the property market will support construction activity and investment. Chart I-10How Long Will The Weakness In China Last? House prices have been rising to the tune of 10%-15% year-on-year, and may be sniffing an eventual pick-up in property volumes. Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufacturers cutting retail prices. This should help retail sales (Chart I-10). Other Global Growth Barometers Investors looking for more clarity on the global growth picture from the April and May data prints remain in a quandary. And the preliminary European PMI numbers this morning offered no glimmers of hope. That said, the most volatile components of euro area growth tend to be investment and net exports. Should they both pick up on the back of stronger external demand, GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently among the weakest in the euro zone. But forward-looking indicators suggest we may be on the cusp of a V-shaped bottom over the next month or so (Chart I-11). Chart I-11German Manufacturing Might Be At The Cusp Of A V-Shaped Recovery The broad message is that global growth is in the midst of volatile bottoming process. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data. We recommend maintaining a pro-cyclical bias at the margin, but having tight stop losses as well as positions in both the Swiss franc and yen as insurance. Housekeeping Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued at the time, the pound was sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit had significantly fallen. Since then, policy-induced volatility has led to a significant depreciation in the pound, with our position at risk of being stopped out at our 1.25 stop-loss this week. Given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-12). The CPI data this week confirm that the domestic environment is hardly deflationary. That said, given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. Chart I-12Hold GBP/USD, But Stand Aside At 1.25 Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: The Michigan consumer sentiment index jumped to 102.4 in May. However, the Chicago Fed national activity index fell to -0.45 in April. The Redbook index increased by 5.4% year-on-year in May. Existing home sales contracted by 0.4% month-on-month to 5.2 million in April. Moreover, new home sales fell by 6.9% month-on-month in April. The Markit composite index fell to 50.9 in April. The manufacturing and services PMI fell to 50.6 and 50.9 respectively. Importantly, this a just a nudge above the 50 boom/bust level. DXY index initially increased by 0.3%, then plunged on the weak PMI data, returning flat this week. The FOMC minutes released on Wednesday reiterated that the recent drop in core inflation is mostly transitory, and that no strong evidence exists for a rate change in either direction. With the forward market already pricing an 82% probability of a rate cut this year, any hawkish shift by the Fed will be a surprise. However, this will not necessarily be bullish for the dollar, if accompanied by a global growth bottom. We remain of the view that the path of least resistance for the dollar is down. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline consumer price inflation was unchanged at 1.7% year-on-year in April, while core inflation increased to 1.3%. The current account balance narrowed to a surplus of 24.7 billion euros in March. However, this was above expectations. German GDP was unchanged at 0.6% year-on-year in Q1. The euro area Markit composite PMI was flat at 51.6 compared to the last reading of 51.5. Below the surface, both the manufacturing and services PMIs fell to 47.7 and 52.5, respectively. German composite PMI was held up at 52.4 by the services component that came in at 55. However, the manufacturing component fell to 44.3. German IFO current assessment dropped to 100.6 in May, and the business climate dropped to 97.9. In France, the Markit composite PMI came in at 51.3. The manufacturing and services PMIs both increased, to 50.6 and 51.7 respectively. This was the one bright spot in euro area data. EUR/USD has been flat this week, with recent data being on the softer side. The PMI data remain subdued, in particular. Meanwhile, political uncertainties continue to weigh on investors’ sentiment. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Q1 annualized GDP grew by 2.1% quarter-on-quarter, well above estimates. Industrial production fell by 4.3% year-on-year in March, but was higher than the previous reading of -4.6% in February. Capacity utilization fell by 0.4% month-on-month in March. Exports contracted by 2.4% year-on-year in April, while imports increased by 6.4% year-on-year. The total trade balance thus narrowed from ¥528 billion to ¥64 billion. Notably, the exports to China fell by 6.3%, while exports to the U.S. increased by 9.6%. Machinery orders fell by 0.7% year-on-year in March. Nikkei manufacturing PMI fell below 50, coming in at 49.6 in May. USD/JPY fell by 0.5% this week. Yutaka Harada, a dovish member of the BoJ, warned during a news conference that by hiking the consumption tax rate at this critical juncture, Japan could risk sliding into a recession. With core CPI far from its 2% target, more monetary easing is probably exactly what the doctor ordered. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been firm: The Rightmove house price index increased by 0.1% year-on-year in May. The orders component of the CBI industrial trends survey decreased to -10 in May. Retail sales increased by 3% year-on-year in April. Producer prices and input prices increased by 2.1% and 3.8%, year-on-year respectively in April. Headline inflation and core inflation increased by 2.1% and 1.8% year-on-year in April, both below expectations. GBP/USD decreased by 0.6% this week. Teresa May offered MPs a vote on a second referendum on Brexit, which considers a tighter customs union with the EU. The ongoing Brexit chaos has increased volatility in the pound. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 117.2 this week. Westpac leading index fell by 0.1% month-on-month in April. Completed construction work fell by 1.9% in Q1. AUD/USD fell by 0.3% this week. During this week’s federal election, the coalition government led by Prime Minister Scott Morrison won. Besides the political development, the RBA governor Philip Lowe gave a speech on Monday, highlighting external shocks to Australian economy. He also expressed the positive outlook for Australian economy in the second half of 2019 and 2020, supported by the ongoing capex in infrastructure and resources sectors, together with strong population growth. More importantly, he mentioned that the RBA would consider the case for lower interest rates, which is a dovish shift from previous speeches. We are long AUD/USD with a tight stop at 0.68. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Credit card spending growth missed expectations, coming in at 4.5% year-on-year in April. Retail sales increased by 0.7% quarter-on-quarter in Q1. Retail sales excluding autos increased by 0.7% quarter-on-quarter in Q1. NZD/USD fell by 0.3% this week. NZD/USD is currently trading at a 7-month low around 0.65. A bleak external picture is worrisome for the kiwi. We continue to favor the AUD/NZD cross, from a strategic standpoint. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: Retail sales increased by 1.1% month-on-month in March. In particular, retail sales excluding autos increased by 1.7% month-on-month, well above estimates. USD/CAD appreciated by 0.3% this week. The better-than-expected retail sales data in March sparked a small rally in the loonie. However, the rally proved to be short-lived following softer oil prices. Positive data surprises in Canada will have to be sustained for the loonie to find some measure of support. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in the Switzerland have been positive: Money supply (M3) growth was unchanged at 3.5% year-on-year in April. Industrial production increased by 4.3% year-on-year in Q1, albeit lower than the last reading of 5.1%. USD/CHF fell by 0.8% this week. As we argued in last week’s research note, the increasing global market volatility has reignited interest in the Swiss franc. We continue to recommend the franc as an insurance policy amid rising geopolitical risk. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week: The unemployment rate came in at 3.5% in March, well below consensus of 3.7% and the previous reading of 3.8%. USD/NOK fell by 0.4% this week. Rising geopolitical risks will be supportive of the oil market and put a floor under the krone. Aside from the U.S.-Iran tensions, the world faces the prospect of the loss of Venezuelan production, and significant outages in Libya, which are all bullish. Meanwhile, Norway remains one of few G10 countries that can hike interest rates in the near term. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased by 0.5% in Q1. Moreover, the unemployment rate fell to 6.2% in April. This was well below expectations of 6.8% and the previous month’s reading of 7.1%. USD/SEK fell by 0.3% this week. While we favor both the NOK and SEK against the U.S. dollar, near-term factors are more bullish for the krone. Our long NOK/SEK position is currently 4.38% in the money. Stick with it. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
U.S. markets are closed this Memorial Day Monday. The key releases for the week will be consumer confidence on Tuesday, the second release of Q1 GDP on Wednesday, and the personal income and outlays on Friday. This last data set includes the core PCE…
Highlights So What? Markets remain complacent about U.S.-China trade. Why? The U.S. has escalated the trade war by threatening sanctions on key Chinese tech firms. Chinese President Xi Jinping is preparing his domestic audience for protracted struggle. U.S. domestic politics do not prohibit, and likely encourage, a tough stance on China. Farmers are not a constraint on Trump — economic growth is. Go long spot gold and JPY-USD. Feature Markets remain complacent. Chart 1 suggests that while the combination of unilateral trade tariffs and spiking U.S. 10-year Treasury yields was enough to sink the S&P 500 in 2018, the former alone cannot do so today. Chart 1Tariffs Alone Not Enough To Sink Equities? Wrong. Specifically, the increase in the Section 301 tariff rate from 10% to 25% on $200 billion worth of Chinese imports and the threat of a new 25% tariff on the remaining $300 billion worth of Chinese imports in just a month’s time has only led to a 3% pullback in equities since May 3. That was the last trading day prior to President Donald Trump’s infamous tweet about hiking the tariff. Unlike the trade war escalation in October through November of last year, the Federal Reserve is no longer hiking rates, China’s economic indicators have bottomed, and U.S. equity investors have now fully imbibed the “Art of the Deal.” The consensus holds that the escalation of trade tensions with China is contained within the context of Trump’s well-known routine of inflicting pain and then compromising. We would wager that the bond market is right and equities are wrong. Equities will converge to the downside, unless the market receives a concrete positive catalyst that improves the near-term outlook for U.S.-China relations and hence global trade. The problem is that for equities such a catalyst could happen at any time in the form of additional Chinese stimulus. Therefore, higher volatility is the only guaranteed outcome. The sudden onslaught of U.S. pressure makes it harder for Chinese President Xi Jinping to offer structural concessions to his American counterpart without looking weak. It was easier to do so when the threat of tariffs was under wraps, as was the case between December 1 and May 5. This new obstacle informed our decision to close out our long China equities and long copper trades and downgrade our end-June trade deal probability from 50% to 40%. But the escalation of tensions makes stimulus more likely to surprise to the upside, which will at least partially offset the negative hit to global sentiment and the trade outlook. Waiting For A Positive Political Intervention Three negative geopolitical catalysts loom in plain sight, while investors are still waiting on a positive catalyst. The negatives: China has not yet announced retaliation to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms; the U.S. could implement the blacklist within three months, increasing the risk of a broader “tech blockade” against China; and the U.S. authorities are prepared to extend tariffs to all Chinese goods in one month. Meanwhile there are no high-level talks currently scheduled between the principal Chinese and American negotiators as we go to press. This could change quickly. But if negotiating teams do not hold substantive meetings with positive reports afterwards, then investors cannot be sure that Presidents Donald Trump and Xi Jinping will speak to each other, let alone finalize a substantive trade deal, at the G20 in Japan on June 28-29. The macro backdrop is hardly encouraging: global export volumes are contracting and the dollar’s fall may be arrested amid a huge spike in global policy uncertainty. Any rebound in the greenback will pile additional pressure onto trade flows, at least until the market sees a substantial increase in Chinese stimulus (Chart 2). Furthermore, it is concerning that President Trump, a businessman president and champion of American manufacturing, is raising tariffs at a time when lending and factory activity are already slowing in the politically vital Midwestern states (Chart 3). The implication is that he is unfazed by economic risks and therefore less predictable. He is pursuing long-term national foreign policy objectives at the expense of everything else. This may be patriotic but it will be painful for global equity investors. Chart 2Trump Unfazed By Deteriorating Global Economy Chart 3Economic Activity Is Already Slowing Chart 4Markets Blasé About Looming Risks It is not only the S&P 500 that is failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Our colleague Anastasios Avgeriou of the BCA U.S. Equity Strategy points out that the “Ted spread,” the premium charged on interbank lending over the risk-free rate, is as docile as the safe-haven Japanese yen (Chart 4). President Xi Jinping, however, is not so blasé. He took a trip to Jiangxi province on May 20 to declare that China is embarking on a “new Long March.” This is a reference to the legendary strategic withdrawal executed by the early Chinese Communist Party in its civil war against the nationalists in 1934-35. It was an 8,000-mile slog across the rugged terrain of western and central China, peppered with battles against warlords and nationalists, in which nearly nine-tenths of the communist troops never made it. It is a historical event of immense propagandistic power used to celebrate the CPC’s resilience and ultimate triumph over corrupt and capitalist forces backed by imperialist Western powers. Most importantly, the Long March culminated in Mao Zedong’s consolidation of power over the party and ultimately the nation. In short, President Xi just told President Trump to “bring it on,” as he apparently believes that a conflict with the U.S. will strengthen his rule. The S&P 500 and the “Ted spread” are failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Trump, meanwhile, operates on a much shorter time horizon. He is coming closer to impeachment, as House Speaker Nancy Pelosi sharpens her rhetoric and negotiations over a bipartisan infrastructure bill collapse. Impeachment will fail and in the process will most likely help Trump’s reelection chances. But gridlock at home means that one of our top five “Black Swan” risks for 2019 is now being activated: Trump is at risk of becoming a lame duck and is therefore looking for conflicts abroad as a way of stirring up support at home. Bottom Line: The bad news in the trade war is all-too-apparent while good news is elusive. Yet key “risk off” indicators have hardly responded. We recommend going long JPY-USD on a cyclical basis on the expectation that the market will continue to have indigestion until a positive catalyst emerges in the trade talks. Trump’s Trade War Calculus The trade war is focused on China more so than other states – and Trump likely has the public backing for such a conflict. President Trump delayed any Section 232 tariffs on auto and auto parts imports this month as the China trade war escalated (Chart 5). This confirms our reasoning that the nearly 50/50 risk of tariffs on car imports from Europe and Japan (recently upgraded from 35%) is contingent on first wrapping up a China deal. Another signal that Trump is conscientious not to saddle the equity market with too many trade wars is the decision finally to exempt Canada and Mexico from Section 232 aluminum and steel tariffs (Chart 6). It is now possible for Canada to ratify the deal before parliament dissolves in late June and for the U.S. and Mexico to follow. American ratification will involve twists and turns as the Democrats raise challenges but their obstructionism is ultimately fruitless as it will not hurt Trump’s approval ratings and labor unions largely support the new deal. Meanwhile a major hurdle relating to Mexican labor standards has already been met. These are positive developments for these markets and yet they call attention to a critical point about the Trump administration’s trade strategy: Trump has not shown much willingness to compromise his trade demands with allies in order to secure their cooperation in pressuring China. The threat of car tariffs is still looming over Europe (and even Japan and South Korea). In fact, a united front among these players would have made it much harder for China to resist structural changes (Chart 7). Chart 6Canada And Mexico Are Off The Hook Chart 7A 'Coalition Of The Willing' Would Be More Effective Nevertheless, we have long held that China, not NAFTA or Europe, would be the focus of Trump’s ire because there is much greater consensus within the U.S. political establishment on the need for a more muscular approach to China grievances, and hence fewer constraints on Trump. This view has now come full circle, at least for the time being. Bear in mind that while Republicans and even Democrats have a favorable view of international trade, in keeping with an improving economy (Chart 8), the U.S. as a whole is more skeptical of free trade than most other countries (Chart 9). The economy is insulated and globalization has operated unchecked for several decades, generating resentment. This is especially relevant with China. Americans have an unfavorable view of China’s trade practices and China in general (Charts 10 and 11). This perception is getting worse as the great power competition heats up. Even a majority or near-majority of Democrats view China’s cyber-attacks, ownership of U.S. debt, environmental policies, and economic competition as causes of real concern (Chart 12). This means Trump is closer to the median voter when he is tough on China. The result is a lower chance of a “weak deal,” i.e. a short-term deal to reduce the trade deficit primarily through Chinese purchases of commodities, since this will be a political liability for Trump. He may be forced into such a deal if the market revolts (say 35% odds). But otherwise he will hold out for something better, which Xi Jinping may be unwilling to give. China, not NAFTA or Europe, is the focus of Trump’s ire. This is why we rank “no deal” at 50%, more likely than any kind of deal (40%), though there is some chance of an extension of talks beyond the June G20 (10%). Bottom Line: The delay of auto tariffs and progress in replacing NAFTA suggest that the Trump administration is cognizant of the negative market impact of its trade wars and the need to focus on China. However, the risks to Europe and Japan are not yet removed. And any Chinese concessions will be weaker than might otherwise have been possible had Trump created a “coalition of the willing” to prosecute China’s violations of global trading norms. A weak deal makes it more likely that strategic conflict is the result. Trump Beats Bernie Beats Biden? Or Vice Versa? U.S. domestic politics are also pushing Trump in the direction of conflict with China. The American voter’s distrust of China explains why former Vice President Joe Biden, and leading contender for the Democratic Party nomination in 2020, recently caught flak from both sides of the aisle for being soft on China. At a campaign stop in Iowa on May 1, Biden said, “China is going to eat our lunch? Come on, man … They’re not competition for us.” He has made similarly dovish comments in the recent past. It makes sense, then, that Trump is trying to link “Sleepy Joe” (as he calls Biden) with weakness on China and trade. Biden, who is still enjoying a very sizable bump to his polling a month after formally announcing his candidacy (Chart 13), is a direct threat to Trump’s electoral strategy of maximizing white blue-collar turnout and support, particularly in the Midwestern swing states. Biden was on the ticket when President Barack Obama won these states in 2008 and 2012. He is a native son of Pennsylvania. And he appeals to the same voters as a plain-talking everyman. Both Biden and Democratic Socialist Bernie Sanders of Vermont are beating Trump in the very early head-to-head polling for the 2020 presidential race. In fact, Sanders has a bigger lead over Trump than Biden in many of these polls (Chart 14). Yet Sanders has a narrower path to victory in the general election – he is heavily dependent on the Rustbelt, where he could either win based on repeating the 2016 results in a new demographic context (the “Status Quo” scenario in Chart 15), or by winning back the blue-collar voters who abandoned the Democrats for Trump in 2016 (the “Blue Collar Democrats” scenario). Sanders performed well in these states in the Democratic primary in 2016, whereas he struggled in the South. Chart 16Democrats Swung Too Far Left For Many Independents Biden, on the other hand, is capable of winning not only in these two scenarios, but also by rebuilding the Obama coalition. He has a better bid to win over the black community due to his close association with Obama and his command of Democratic Party machinery, plus potentially his choice of running mate (the “Obama vs. Trump” scenario). By this means Biden, unlike Sanders, can compete against Trump in the Sun Belt and South in addition to the Midwest. Therefore, it is all the more imperative for Trump to try to corner Biden and frame the debate about Biden early. Trump may also be betting that despite the head-to-head polling, Sanders is too far left for the median voter. While the Democratic Party swings sharply to the left, the median voter remains more centrist, judging by the fact that independent voters (who make up half the electorate now) only slightly favor Democrats over Republicans, a trend that is only slightly rising (Chart 16). Biden’s polling is strong enough that he holds out the prospect of winning the Democratic nomination relatively smoothly, without deepening the ideological split in the party too much. Whereas Trump would benefit in the general election if Democrats suffered an internal split over a bloody primary season in which Bernie Sanders clawed his way to the nomination. The hit to American farmers is probably not a significant political constraint on President Trump waging his trade war. The upshot is that Trump is vulnerable in U.S. politics and will attempt to take action to strengthen his position. Meanwhile if Biden’s position on trade changes then we will know that he reads the Midwestern voter the same way Trump does – as a protectionist. Bottom Line: Trump’s eagerness to attack Biden reveals the specific threat that Biden poses to Trump’s electoral strategy as well as Trump’s calculus that a belligerent position on China is a vote-getter in the key Midwestern swing states. We expect Biden to become more hawkish on China, which will emphasize the long-term nature of the U.S.-China struggle and confirm the median voter’s appetite for hawkish policy. American Farmers Unlikely To Alter The 2020 Playing Field Yet can Trump’s political base withstand the trade war? And can he possibly win the swing states if the trade war is escalating and damaging pocketbooks? There are many stories about farmers in the Midwest and other purple states who are deeply alarmed at Trump’s trade policies, prompting questions about whether he could be unseated there. American farmers have been among the hardest hit in the trade war. China was a major market for U.S. agricultural exports prior to the conflict (Chart 17). Since then U.S. agriculture has struggled, as exports to China have declined by more than 50% y/y in 2018 (Chart 18). Agricultural commodity prices are down ~10% since a year ago, with soybeans – the poster child of the conflict – trading at 10 year lows. Net farm incomes – a broad measure of profits – were on a downward trend prior to the trade war (Chart 19). While the USDA estimates that overall U.S. farm income will increase by 8.1% y/y this year, this follows a nearly 18% y/y decline in 2018 to reach the lowest level since 2002 (Chart 20). The recent escalation of the trade war will weigh on these incomes. A common narrative in the financial media is that this hit to American farmers is a significant political constraint on President Trump in waging his trade war. He could be forced to accept a watered-down deal with China to preserve this voting bloc’s support ahead of November 2020, the thinking goes. Possibly, but probably not because of farmers abandoning the Republican Party en masse. First of all, rural counties and small towns continued supporting the Republican Party in the 2018 midterms, at a time when the initial negative impact of the trade war was front-page news (Chart 21). Second, some of the key farm states are unlikely to be key swing states in the election. Take soybeans, for example. Prior to the trade war, nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, ended up in China. Illinois is the top producer, followed by Iowa and Minnesota. Last year soybean production in these three states accounted for 15%, 13%, and 8% of total U.S. production, respectively. As such, agriculture and livestock products exports to China in 1Q2019 are down 76% y/y in Illinois and 97% y/y in Minnesota. However, Trump won Iowa by nearly 150 thousand votes, a 9.4% margin, and there are not enough farmers in the state to overturn that margin. The negative impact on soybeans could prevent Trump from picking up Minnesota, where he lost by only 1.5% of the vote. But Minnesota is unlikely to cost him the White House in 2020. The picture is different in the key swing states of Michigan, Pennsylvania, and Wisconsin. Farming accounts for only ~1% of jobs in Michigan, Ohio, and Pennsylvania – and 2.3% of jobs in Wisconsin – and thus farmers represent a small share of the voting bloc in these states (Chart 22). But Trump won Michigan by a mere 0.23% of the vote, Pennsylvania by 0.72%, and Wisconsin by 0.77%. If one-fifth of farmers in these states switched their vote, Trump’s 2016 margin of victory would vanish. Of course, manufacturers are a much larger voting bloc (Chart 23). And rural voters are unlikely to shift to the Democrats on such a large scale. Moreover, ag exports from these states have generally held up (Chart 24), the majority of their exports are destined for North America rather than China. The benefit from the recent thaw in North American trade relations will outweigh the loss of China as a market (Chart 25). The Trump administration is also producing an aid package worth at least $15 billion to shield farmers at least partially from the trade war impact.1 This compares to an estimated $12 billion loss in net farm income in 2018. Ultimately, Trump is much more threatened by other voting groups in these states. Young voters, women, minorities, suburbanites, and college-educated white voters all pose a threat to his thin margins if they turn out to vote and/or increase their support for the Democratic Party in 2020. A surge in Millennials, for instance, played the chief role in unseating Republican Governor Scott Walker in Wisconsin in 2018 (Chart 26). While midterm elections differ fundamentally from presidential elections, the Republicans lost 10 out of 12 significant elections in the Midwest during the midterms (Table 1). Table 1Republicans Lost Almost All Significant Midwest Elections In The Midterm It is true that the winning Democratic candidates in the six major statewide races in Michigan, Pennsylvania, and Wisconsin all had voters who believed Trump’s trade policies were more likely to “hurt” the local economy than help it, according to exit polls (Chart 27). At the same time, a majority of voters believed that the trade policies either “helped” the local economy or “had no impact,” as opposed to hurting it. And Democrats are somewhat divided on this issue. Health care, not the economy, was the primary concern of voters. Moreover, health care, not the economy, was the primary concern of voters, especially Democratic voters (Chart 28). Republicans cared more about the economy and tended to support Trump’s trade policies. In sum, unless the trade war causes a general economic slowdown that changes voter priorities, Trump’s chief threat in 2020 comes from urban and suburban voters angry over his attempt to dismantle the Affordable Care Act, rather than from farmers suffering from the trade war. The large bloc of manufacturing workers in the Midwestern battleground states helps to explain why Trump is willing to wage a trade war at such a critical time: loyal rural counties bear the brunt of the economic pain yet a tough-on-China policy could bring out swing voters from the manufacturing sector in suburbs and cities. Bottom Line: Trump could very well lose agriculture-heavy swing states in 2020, but it would not be because of losing his base among rural voters. Rather, it would be a result of a broader economic slowdown – or a superior showing of key demographic groups in favor of Democrats for other reasons like health care. The large bloc of manufacturing voters relative to Trump’s margins of victory helps to explain his aggressive posture on the trade war. Investment Conclusions Go long JPY-USD on a cyclical, 12-month horizon in the context of escalating trade war, complacent markets, and yet the prospect of additional Chinese stimulus improving global growth. This trade should be reinforced by the specific hurdles facing Japan over the next three to 18 months. While we would not be surprised if a trade agreement with the U.S. is concluded quickly, even ahead of any U.S.-China deal, nevertheless Japan faces upper house elections, a potential consumption tax hike, and preparations for a contentious constitutional revision and popular referendum on the cyclical horizon. On the expectation of greater Chinese stimulus, we are maintaining our long China Play Index call, which is up 2.2%. As a hedge against both geopolitical risk and the impact of Chinese stimulus over the cyclical horizon, go long spot gold. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 While the plan is yet to be finalized, payments of ~$2/bushel to soybean farmers, $0.63/bushel to wheat farmers, and $0.04/bushel to corn farmers are under consideration. Unlike last year when the payments were distributed according to farmers’ current production, a potential modification to this year’s plan is that the payments will be distributed based on this years’ planted acreage and past yields.
While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories…
The barrage of bad news in the past 24 hours is impressive. As the U.S. is extending its blacklist of Chinese companies, fears are growing that a resolution to the trade tensions is more elusive than ever. Moreover, Japanese flash manufacturing PMIs have…
Highlights In the second half of 2019, economic growth will stop accelerating… …but an underpinning of equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges. The equity market will end up in a sideways channel… …but defensives, such as healthcare, will outperform economically-sensitive sectors. Overweight Euro Stoxx 50 versus Shanghai Composite. Overweight the JPY. Bitcoin is due another technical correction. Feature The 2019 playbook for economies and markets is playing out exactly as we predicted. In our first report of this year we wrote that 2019 would be the economic and investment opposite of 2018. Opposite to 2018 because the first half of 2019 would see inflation fade, and growth accelerate. And opposite to 2018 because the second half of 2019 would see inflation stop fading, and growth stop accelerating (Chart of the Week). Chart of the WeekIn The First Half Of 2019, Inflation Faded, Growth Accelerated Inflation Faded, Growth Accelerated Back in early January, we wrote: “Inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater ‘dependence on the incoming data’, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields.” This was a controversial view at the time. Yet within a month of writing, the Federal Reserve had stopped hiking interest rates, while the ECB and other major central banks had also pivoted to more dovish. We also wrote: “Germany should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-2). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.” 1 2019 is the economic and investment opposite of 2018. We now know that the German economy accelerated to a close-to-trend 1.7% clip in the second quarter, up from a -0.8 percent rate of contraction in the third quarter of 2018 (Chart I-3). This is not just due to relief in the auto sector. Growth in other European economies has also rebounded, so the acceleration in growth has a broader foundation, and is now beyond doubt. Given the openness of the European economy, it is also inconceivable that this growth pick-up does not reflect a more generalized acceleration in global activity.2 Chart I-2The WTLP Drag On German Auto Exports Is Over Chart I-3German GDP Growth Accelerated To A 1.7 Percent Clip To repeat, the 2019 playbook for economies and financial markets is playing out exactly as expected; in the first half of the year, inflation faded while growth accelerated. The question is: what happens next? Growth Will Struggle To Accelerate Further Clients ask us an important theoretical question: what is the most important driver for the economy and financial markets; is it the change in the bond yield (or interest rate) or is it the level of the bond yield? The answer is that both the change and the level of the bond yield are important in their different ways. The German economy accelerated to a close-to-trend 1.7% clip in the second quarter. When it comes to accelerations and decelerations in credit creation, it is the change in the bond yield that is the most important. Remember, GDP is a flow statistic, which means that GDP growth is a change of flow statistic receiving contributions from the change of flow of credit. As changes in the flow of credit result from the change in the bond yield – all else being equal – it is the change in the bond yield that drives GDP growth. If all of this sounds somewhat confusing, then Chart I-4 should make the point crystal clear. Chart I-4The Change In The Bond Yield Drives GDP Growth Since last November, high-quality 10-year bond yields have plunged 70 bps, and this collapse in yields helped to provide a strong impulse to growth in the first half of 2019. To receive the same impulse again in the second half, bond yields would have to plunge another 70 bps. But with the German 10-year bund yield already at -0.1 percent, the same rate of decline seems highly unlikely, if not mathematically impossible. The upshot is that the growth impulse from declining bond yields can only fade in the second half of this year. However, when it comes to valuations and solvencies in the financial markets, it is the level of the bond yield that is the most important. Essentially, at a tipping point, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse on the economy. The growth impulse from declining bond yields can only fade in the second half of this year. How can we sense this tipping point? It broadly equates to when the sum of the 10-year yields on the T-bond, German bund, and JGB is at 4 percent, the ‘rule of 4’ (Chart I-5). Conversely, when the sum is below 3 percent, the ‘rule of 3’, – as it is now – the seemingly rich valuation of equities versus bonds is broadly justified (Chart I-6).3 Chart I-5When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent Chart I-6The Rule Of 4, And The Rule Of 3 The upshot is that in the second half of 2019, economic growth will stop accelerating, but the support to equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges (Chart I-7). In aggregate, the equity market will end up in a sideways channel, but defensives, such as healthcare, will outperform economically-sensitive sectors. Chart I-7The Low Expected Return On Equities Is Justified When Bond Yields Are Ultra-Low How Did We Do? In our first report of the year, we also made (or reiterated) five investment recommendations. Today, we will review whether they worked or not, and what to do with them now. 1. Own a 25:75 combination of European banks relative to market, plus U.S. T-bonds. Chart I-8Banks Didn’t Outperform, But Bonds Did! Did it work? Yes. Although European banks underperformed the market, this was more than offset by the huge rally in T-bonds that resulted from the Fed going on hold (Chart I-8). Hence, the position is up 1 percent this year and 3.5 percent since its inception last November with the added advantage of negligible volatility. What to do now. Take profits. 2. Overweight EM versus DM. Did it work? No. EM has underperformed DM this year, though the position is broadly flat since its inception in November. What to do now. Close this position and switch into overweight Euro Stoxx 50 versus Shanghai Composite. 3. Overweight European versus U.S. equities. Did it work? The position is flat this year, though modestly up since its inception in November. What to do now. Maintain the position for a little while longer, as an expected short-term underperformance of the tech sector should benefit the tech-lite European equity market. 4. Overweight Italian assets versus European assets. Did it work? The position is broadly flat this year for both Italian equities and bonds relative to their European benchmarks. What to do now. Close any cyclical exposure to Italy, but maintain a structural exposure to Italian BTPs either in absolute or relative terms. 5. Overweight the JPY. Chart I-9In Japan And Europe, The Expected Interest Rate Cannot Go Much Lower Did it work? Yes. The broad trade-weighted JPY has outperformed this year, and especially so the JPY/EUR cross. What to do now. Maintain the position. When the expected interest rate is at its lower bound, then it is difficult for the central bank to hurt its currency. In technical terms, the currency possesses a highly attractive payoff profile called positive skew (Chart I-9). Of course, there are plenty of currencies whose interest rates are near the technical lower bound, but we like the JPY because it has less political risk than the others. So for the moment, remain overweight the JPY. Fractal Trading System* This week we note that after a 100 percent rally in a near straight line, bitcoin’s 65-day fractal dimension is at the lower bound that has reliably signaled previous technical corrections. On that basis, this week’s recommended trade is short bitcoin, setting the profit target and symmetrical stop-loss at 27 percent. Also, we are very pleased to report that short tech versus healthcare quickly achieved its 6.5 percent profit target and is now closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1 2018. 2 Quarter-on-quarter real GDP growth at annualized rates. 3 Please see the European Investment Strategy Weekly Report “The Rule of 4 Becomes the Rule of 3” dated March 21, 2019 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s…
Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more…
Highlights Global financial markets are currently dealing with a fresh round of uncertainty related to U.S.-China trade tensions. Yet while equities and government bond yields have fallen in response to the U.S. imposition of tariffs and escalation of the trade war with China, corporate bond markets in the developed economies have been relatively well-behaved (so far). Credit spreads have only widened modestly, which perhaps should not be surprising given central bankers’ increasingly dovish bias combined with early signs of a cyclical global growth rebound (Chart 1). Feature Chart 1Global Corporates: Shifting To A Friendlier Growth Backdrop? With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The main conclusion from the latest readings on our CHMs is that slower economic growth over the past year has resulted in some erosion of overall global credit quality. The deterioration was most pronounced in the more economically fragile regions that have suffered the deepest pullbacks in growth: Europe and Japan. The CHMs are currently giving an overall “neutral” signal in the U.S., although there are some worrying trends developing within the sub-components like interest coverage and short-term liquidity. Meanwhile, the CHMs in the U.K. and Canada are showing modest cyclical deterioration from very strong levels. Broadly speaking, the CHMs support our main global corporate bond market investment recommendations: a tactical aggregate overweight versus global government bonds, with a regional bias favoring the U.S. over Europe, and a quality bias tilted towards U.S. high-yield (HY) over investment grade (IG). Renewed U.S.-China trade hostilities represent a threat to that pro-cyclical fixed income asset allocation, although we expect more aggressive responses from policymakers on both sides (more fiscal and monetary stimulus in China, a more dovish bias from the Fed) to offset any tariff-induced weakness in growth. U.S. Corporate Health Monitors: Cyclically OK, But Longer-Term Problems Are Brewing Our top-down U.S. CHM is sending a neutral message on credit quality, sitting right on the threshold separating “deteriorating health” from “improving health” (Chart 2). The indicator, however, has been trending in a direction showing improving credit metrics over the past year. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate tax cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. The ratios directly related to corporate profits that go into the top-down CHM – return on capital, profit margins and interest coverage – have all gone up over the past year, generating the bulk of the directional improvement in the top-down CHM. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. That does not mean that all the news is good, however. The short-term liquidity ratio has fallen sharply and is now at levels last seen in the years leading up to the 2008 Financial Crisis. Similar deteriorations can be seen in the short-term liquidity ratios within the bottom-up versions of our U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Coming at a time when interest coverage ratios have been steadily declining for IG, and are already at low levels for HY, declining short-term liquidity would leave U.S. corporates highly vulnerable during the next economic downturn. Chart 2Top-Down U.S. CHM: A Neutral Reading Chart 3Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates. For now, however, the message from our bottom-up U.S. CHMs is the same as that from our top-down U.S. CHM, with all hovering near the zero line suggesting no major deterioration in overall credit quality. We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). Our favored indicators continue to point to a rebound in global growth in the latter half of 2019, and the Fed currently has no desire to push the funds rate into restrictive territory, so the risk/reward over the next six months still favors staying overweight U.S. corporates. The medium-term outlook, however, is far more challenging given the growing body of evidence pointing to the advanced age of the U.S. credit cycle, such as falling interest coverage and liquidity. Chart 4Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY One final point – in Appendix 2 starting on page 17, we present bottom-up CHMs for the main industry sector groupings of companies that go into our overall U.S. IG CHM. Most of the sector CHMs are hovering near the zero line, but two industry groupings stand out as having a rising CHM that is now well within “deteriorating health” territory – Consumer Staples and Utilities. Euro Corporate Health Monitors: Worsened By Weaker Growth The message from our bottom-up CHMs for the euro area shows that there was some damage done to credit quality from last year’s growth slump, evidenced by lower profit margins and interest coverage ratios. Although overall credit quality remains fairly neutral (i.e. the CHMs remain near the zero line). For euro area IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former now slightly in the “deteriorating health” zone (Chart 6). Profit margins have fallen far more sharply for domestic issuers, reflecting the very rapid slowing of euro area growth over the latter half of 2019. Interest coverage for domestic issuers is also lower than for foreign issuers, while short-term liquidity ratios have weakened for both over the past year. For euro area HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, and are now hovering just above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. Despite the lack of a major overall negative signal from the euro area CHMs, we are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates (Chart 9). The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. This will inhibit the ability for spreads to tighten further in the event of a pickup in growth, while also leaving spreads vulnerable to widening pressures if euro area growth continues to languish. Chart 8Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. The gap between the combined IG/HY bottom-up CHMs for the U.S. and euro area has been strongly correlated to the difference in credit spreads between euro area and U.S. issuers (Chart 10).1 The latest trends show a narrowing of the gap between the U.S. and euro area CHMs, suggesting relative corporate health favors U.S. names (middle panel). At the same time, the relatively stronger performance of the U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). U.K. Corporate Health Monitor: Brexit Uncertainty Is Not Helping Our top-down U.K. CHM remains in the “improving health” zone, although the indicator has been drifting towards “deteriorating health” over the past two years. Almost all of the components of the U.K. CHM have contributed to this worsening trend (Chart 11), with only short-term liquidity remaining in a powerful multi-year uptrend. Most worryingly, the interest and debt coverage ratios remain historically depressed, even as the Bank of England has keep interest rates at extraordinarily low levels for the past several years. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The persistent uncertainty from Brexit has weighed on business confidence and investment spending by U.K. firms, keeping growth at a below-trend pace. While the immediate deadline of “Brexit Day” came and went back in March, there is still a high degree of uncertainty over the U.K.’s future economic relationship with the European Union. With Prime Minister Theresa May now set to step down, an election will extend the period of politically-driven uncertainty in the U.K. We have maintained a moderate underweight recommendation on U.K. corporates in our model bond portfolio over the past year, despite the lack of an obvious negative signal from our U.K. CHM. Spread widening in 2018 has been followed by spread tightening in 2019 (Chart 12), but the latter has been driven by the global rally in risk assets rather than diminished perceptions of U.K. political risk. Chart 11U.K. Top-Down CHM: Modest Pullback From Healthy Levels Chart 12U.K. Corporates: Stay Modestly Underweight Although there has been some improvement in U.K. economic data of late, leading economic indicators continue to trend lower. In addition, the Bank of England continues to hint that any positive resolution to the Brexit uncertainty could result in a tightening of monetary policy (although that is less of a threat given the synchronized dovish turn by global central bankers over the past few months). Given all the uncertainties, the risk/reward balance continues to favor a modest underweight in U.K. corporates, particularly at current tight spread levels to Gilts. Japan Corporate Health Monitor: A Modest Cyclical Deterioration Our bottom-up Japan CHM has shown a worsening trend over the past year and now sits in the “deteriorating health” zone (Chart 13).2 Interestingly, all of the individual components have contributed to that move in the CHM, and not just the cyclical components (profit margins, return on capital, interest coverage) that reflect the recent slowing of economic growth in Japan. Leverage has increased (albeit from very low levels), while short-term liquidity has also weakened (albeit from very high levels). Strictly looking at the overall level of all the Japan CHM components, the message does not signal a major deterioration in Japanese corporate credit quality. Leverage, defined here as the ratio of total debt to the book value of equity, is still below 100%, well below the 100-140% range seen between 2006 and 2015. The same story applies to the return on capital, which at 5% is still high versus Japan’s history (although very low by global standards). Interest coverage and short-term liquidity both remain high relative to the past decade. The absolute level of Japanese corporate health remains solid, but there has been marginal deterioration from weaker economic growth. On that front, the cyclical momentum in Japan’s economy is not improving. According to the latest Tankan survey, Japanese firms reported that their business outlook was worse than previously expected. Declining confidence has damaged capital spending, as shown by the falling growth of domestic machinery and machine tool orders. Japan’s economy remains highly levered to global growth and export demand and their economy has taken a hit from the slower pace of global trade over the past year. Wage growth has also weakened after finally seeing some positive momentum in 2018, which is weighing on consumer confidence and spending. Japan’s corporate spread has widened slightly (+5bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets (the Bloomberg Barclays Global Corporates index spread has tightened by -33bps year-to-date). This is a sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns versus Japanese Government Bonds (JGBs) with yields held near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitor: Still In Decent Shape Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving health” area over the past few years (Chart 15). The marginal moves have shown some modest deterioration in the cyclically-sensitive components (most notably, return on capital and profit margins for the top-down Canadian CHM). This should not be surprising given how rapidly Canadian economic growth slowed in the final quarter of 2018. There has also been some deterioration in the non-cyclical components. Leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are historically low. This may be building up risks for the next major Canadian economic downturn, but for now, Canadian companies look in decent shape. With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next six months, which will further underpin the health of Canadian oil companies – and should also help support Canadian corporate bond performance. The Bank of Canada is now taking an extended pause from its rate-hiking cycle, with policy rates well below the central bank’s own estimate of neutral (2.25-3.25%). Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have been in a very stable range since the 2009 recession (Chart 16), ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a prolonged deterioration of Canadian economic growth or sharp monetary tightening from the Bank of Canada – neither outcome is likely over the next 6-12 months. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.3 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Footnotes 1 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 2 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 3 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns