Developed Countries
Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Chart 3China Already ##br##Imports U.S. Commodities... Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Chart 5... But Impedes Market Access For Higher Value-Added Goods Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Chart 7Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Chart 17Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Chart 20...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Chart 24Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.
Highlights Global Yields: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Feature After knocking on the door of the 3% threshold several times this year, the 10-year U.S. Treasury yield finally blew through that level last week. The ease with which this move occurred was a bit surprising, given that bond investor sentiment has stayed consistently bearish and Treasury market positioning remains extremely short. This raises the odds of a potential pullback in yields if the U.S. economy or inflation were to lose upside momentum. The only problem for the Treasury market is that neither of those trends is occurring at the moment. Chart of the WeekTreasuries Are Losing##BR##For The Right Reasons U.S. real GDP expanded at a 2.3% annualized rate in the first quarter of 2018, and the latest real-time GDP estimates for the second quarter from the Atlanta Fed (+4.1%) and New York Fed (+3.0%) are calling for an acceleration. The leading economic indicators produced by both the OECD and the Conference Board continue to climb higher, in stark contrast to the lost momentum in hard data and lead indicators in other major regions like Europe and Japan (Chart of the Week). Similar divergences are occurring in the inflation data, where core CPI inflation is accelerating in the U.S. and languishing elsewhere. The ability of U.S. Treasury yields to ignore the negative international headlines coming from typical trouble spots like Turkey, Argentina, Italy, Iran and North Korea is impressive. Clearly, none of these developments are big enough (yet!) to have any negative impact on U.S. growth expectations and, in turn, Fed rate hike expectations. At the same time, Fed officials continue to signal that another two or three rate increases are still likely over the remainder of the year. Add in the steady climb in inflation expectations, supported by oil prices reaching multi-year highs, and it is no surprise that those aggressive Treasury short positions have been on the right side of the market. If we were to apply a weather analogy to the global economy, conditions appear "partly sunny" if looking at the U.S, but "mostly cloudy" when looking elsewhere. This has major implications for the future path of U.S. Treasury yields versus other government bond markets, and for the U.S. dollar as well. Expect U.S. Bond Relative Underperformance To Continue From a more global perspective, the ability of non-U.S. bond yields to rise has become more limited. The overall OECD leading economic indicator - which is correlated to real global bond yields - looks to be rolling over, and our diffusion index of individual country indicators shows that this trend is broad-based (Chart 2). Within the major developed economies, only the U.S. stands out as having a rising leading economic indicator (although the Canadian index is holding up at a high level). The most depressed readings come from the three markets we are overweight in our model bond portfolio - the U.K., Japan and Australia (Chart 3). These growth divergences are not only visible in "soft" economic data like leading indicators and purchasing manager indices. U.S. retail sales showed a surprising burst of strength in April, and the release of that data last week was the trigger for pushing the 10-year Treasury yield above 3%. Meanwhile, readings on real GDP growth in the first quarter for the euro area and Japan were quite weak compared to the acceleration seen throughout 2017. In the case of Japan, GDP actually contracted at a 0.6% annualized rate in Q1, ending a run of eight consecutive quarters of positive growth which was the longest such streak in 28 years (Chart 4). Chart 2A Stagflationary Tug-Of-War##BR##On Global Yields Chart 3U.S. Growth##BR##Stands Out Chart 4Is China To Blame For##BR##Slowing Non-U.S. Growth? At the same time, China's domestic economy has seen some slowing of growth, as well, as evidenced by the rapid deceleration of import growth (bottom panel). For the economies in Europe and Japan where growth is still heavily geared towards exports, and where domestic demand still struggles to gain sustainable upward momentum in the absence of an export/production cycle, a slowing China poses a big problem - one that is less of an issue for the more domestically-focused U.S. economy. The divergence of growth and inflation accelerating in the U.S. but potentially peaking out elsewhere, can be seen in the widening of government bond yield spreads between the U.S. and its developed market peers. In Table 1, we show the change in the bond yield spread between 10-year U.S. Treasuries and similar maturity government debt from the U.K., Germany, Japan, Canada and Australia since the last major trough in global yields in September 2017. The spread changes are broken down into movements in inflation expectations and real yields to see which was more influential. For example, of the 75bps widening in the 10-year U.S. Treasury-German Bund spread, 55bps has been due to widening real yield differentials and only 20bps has come from higher inflation expectations in the U.S. Table 1Cross-Country Yield Spread Changes (in bps) Since The September 2017 Low In U.S. Treasury Yields These changes show that the underperformance of U.S. Treasuries (i.e. spread widening) has come mostly though higher real yields in the U.S. Inflation expectations are widening in the U.S., but are also moving higher in all other countries except the U.K. So the relative change in inflation expectations between the U.S. and the other countries has been more modest than the absolute change in U.S. TIPS breakevens (Chart 5). The fact that the real yield differentials are moving increasingly in favor of the U.S. has implications for the U.S. dollar. The greenback has finally begun to appreciate after the weakness seen in 2017, with potentially a lot more room to run judging by the levels implied by those wide real yield gaps. This is most evident for the euro, yen and British pound (Chart 6). Chart 5Higher Inflation Expectations##BR##& Yields In The U.S. Chart 6USD Finally Responding To Wide##BR##Real Yield Differentials The path of the U.S. dollar is the key to how this U.S./non-U.S. growth divergence story will end. If the dollar continues to strengthen as the Fed lifts rates in the coming months, then monetary conditions in the U.S. run the risk of moving into restrictive territory. This could spur a bout of renewed U.S. market turbulence not unlike that seen in 2015 and 2016 when the Fed was trapped in what we described at the time as a "policy loop", where a higher dollar and rising market volatility (especially in the emerging markets) prompted the Fed to delay planned rate hikes. The circumstances are different now compared to three years ago. The dollar is only mildly appreciating from the depressed levels of 2017, U.S. core inflation is approaching the Fed's 2% target, and the U.S. economy is at full employment with fiscal stimulus on the way. In other words, the hurdle for the Fed to alter its current rate hike plans is much higher than it was in 2015/16 when the U.S. economy and inflation were in more fragile states. For now, we continue to see relative growth and inflation trends pushing in a direction for continued U.S. government bond underperformance over the balance of 2018. One-sided bearish positioning may create a backdrop where Treasury yields could fall for a brief period, but the true cyclical peak in yields - somewhere in the 3.25-3.5% range - and in U.S./non-U.S. yield spreads has not been reached yet. Bottom Line: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Worry More About Slowing Growth Than Politics Italian political risk returned to European financial markets last week after details of the policy program for the new Five-Star Movement/League coalition government were leaked to the press. Some of the more alarming proposals included: Having the European Central Bank (ECB) "freeze" or "cancel" the €250bn in Italian government debt it holds via its asset purchase program. Revising the rules of the European Union (EU) Growth and Stability Pact, specifically its fiscal rules on debt and deficits, while also asking for Europe to, more generally, return to a "pre-Maastricht" (pre-euro?) position. These headlines were interpreted as a sign that the populists taking over Italy were looking for a way to loosen fiscal policy in excess of EU rules, if not abandon the euro currency entirely. This would be a realization of the outcome from the March election that investors feared the most. Markets responded as expected, with Italian government bond yields soaring across the entire yield curve and Italian equities and the euro selling off (Chart 7). We last discussed Italy back in February in a Special Report co-written with our colleagues at BCA Geopolitical Strategy.1 We concluded that, even though euroskepticism would continue to have appeal in Italy because support for the common currency is much weaker than in the rest of the euro area (Chart 8), none of the likely coalition partners in a new government would make noise about potentially bringing back the lira with the economy in a cyclical expansion. All of the likely winning coalitions would seek to ease Italian fiscal policy, however, which would bring back investor worries about Italian debt sustainability. Chart 7The Return Of##BR##The Italy Risk Premium Chart 8The Euro Is Still Less Popular##BR##In Italy Than Elsewhere The first part of our conclusion went in a fashion that we did not expect, with the anti-establishment Five-Star party joining forces with the far-right League in a populist coalition that could embrace euroskepticism more emphatically. The second part of that conclusion does appear to be panning out, with the new government already looking to cut taxes and ramp up fiscal spending. These outcomes would be enough for investors to begin pricing in a higher fiscal risk premium in Italian assets, thus justifying the market moves seen last week. Yet there was one other conclusion from our report that is more relevant now for fixed income investors. Italian government bonds would not begin to underperform until there were signs that Italy's economy was slowing - which is what appears to be happening now. Like the rest of the euro area, Italy saw a deceleration of economic growth in the first quarter of the year. The most cyclical components of the Italian economy, manufacturing and exports, have both shown a considerable deceleration. Exports to non-EU countries, in particular, have noticeably slowed (Chart 9), which is likely yet another sign of how slowing Chinese growth is spilling over into much of the global economy through trade channels. Domestic demand has seen some cyclical strength on the back of the surge in exports, production and employment seen in 2016/17. However, the risk now is that slowing exports feed back into slowing production and weaker hiring activity. Any sign of a slowdown would only embolden the new coalition government to aim for easier fiscal policy. That would be a logical response by any government, particularly with current budget forecasts calling for tightening fiscal policy over the next few years. The latest set of debt and deficit projections from the IMF show that Italy is expected to have a balanced budget by 2021 (Chart 10). This would imply that the primary budget balance (i.e. net of interest payments) would rise to as high as 3.6% of GDP - an enormously restrictive policy stance that no advanced economy currently runs. Chart 9Italian Cyclical Momentum##BR##Has Peaked Chart 10This Rosy Trajectory For##BR##Italian Debt Will Not Happen That degree of fiscal tightening also makes the debt dynamics of Italy look much more sustainable, with debt/GDP projected to fall by ten percentage points by 2021 according to the IMF (bottom panel). Given the leanings of the new government, and with the economy starting to lose some momentum, there is zero chance that the IMF deficit and debt projections will come to fruition. In fact, the opposite is likely to happen under the new government, with the fiscal deficit likely to widen and debt/GDP likely to increase. While a return to the "bad old" economic policies of Italy might harken back to the days of the 2011 European debt crisis, there are two major differences between then and now: Italy's borrowing costs are far lower, thanks to the hyper-easy monetary policies of the ECB (both zero/negative interest rates and outright bond purchases). The average debt on newly-issued Italian government debt has plunged from the 6-7% levels around the time of the debt crisis to less than 1% over the past three years, according to the Bank of Italy (Chart 11). This has helped substantially reduce the amount of net interest payments made by the Italian government - by one full percentage point of GDP, according to the IMF. Less Italian debt is owned by non-Italian residents than during the crisis. According to data from the Bruegel think tank in Brussels, the percentage of Italian sovereign debt held by non-Italian residents is now 36%, compared to 50% during the years before the crisis (Chart 12). As that crisis unfolded, those investors rapidly dumped their Italian bonds, cutting their ownership share by ten percentage points in less than one year. Domestic Italian banks were forced to pick up the slack, which increased the already significant fiscal exposure of the Italian banking system. Now, the ownership mix is much more balanced, including the 20% of Italian bonds owned by the ECB. This means that, today, 64% of Italy's debt is owned by those with a vested interest in Italian stability, rather than fickle foreign investors who would be much more willing to dump their bonds when the Italian news turns less favorable. Chart 11The Big Difference Between 2011 & Today Chart 12A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 This is not to say that another Italian debt crisis could not happen, especially if the Five-Star/League coalition were to more seriously discuss a potential exit from the euro. The only difference now is that Italy's debt sustainability issues are not as acute as in 2011 because of the low borrowing costs and more diverse ownership of Italian debt. Chart 13Downgrade Italian Debt To Underweight From a bond strategy perspective, however, we are more focused on the growth dynamics in Italy than the current political noise. As we also concluded in our February Special Report, the time to downgrade Italian debt was when the economy was clearly about to slow, as heralded by a decline in the OECD's leading economic indicator for Italy. That series has been highly correlated to the relative performance of Italian government debt (Chart 13) and, therefore, is a useful indicator to follow to determine Italian bond strategy. With the leading indicator now falling for four consecutive months, and with hard Italian data also starting to slow, a period of Italian bond underperformance has likely just begun - an outcome that can only be made worse by the new euroskeptic and free spending Italian government. Thus, we are downgrading Italy in our country rankings this week to underweight (2 out of 5), and cutting our recommended allocations to Italian debt in our model bond portfolio to ½ index weight. We place the proceeds of that reduction into German bonds across the yield curve. Bottom Line: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Geopolitical Strategy Special Report, "Italy: Growth Cures All Ills ... For Now", dated February 21st 2018, available at gfis.bcaresearch.com and gps.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. The 2017 tax bill, rising energy prices, and banks' willingness to lend all suggest strong capital spending this year. Our view is that stagflation is not a near-term threat. Nonetheless, investors are concerned about a return of a period of decelerating growth and rising inflation. We examine the performance of U.S. financials in and out of stagflation. We reexamine the link between inflation, deficits, credit and money supply growth. Feature Chart 11H GDP Tracking Well Above Potential The VIX moved lower last week even as U.S. bond yields rose. Tensions with North Korea re-escalated, but Trump's trade spat with China eased. On balance, the spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. Economic growth prospects in the U.S. remained upbeat. A series of reports for April and May on housing, consumer spending, manufacturing and capital spending all indicated that real GDP growth in Q2 2018 was tracking to over 4% after a 2.3% gain in Q1, well above the economy's potential growth rate of 1.8% (Chart 1). Capital spending remains poised to lift off in 2018 aided by the supply-side impact of the 2017 tax cut bill and higher oil prices. Despite upbeat economic news in the U.S., there were additional signs last week that growth outside the U.S. was slowing.1 This deceleration, coupled with recent readings on wage and price inflation, suggest that investors may be concerned that stagflation is imminent. BCA's view is that the next bout of stagflation is still several years away. In this week's report, we look at the longer-term relationship between inflation, money supply, credit growth and deficits. Early 2018 Volatility Spike: An Update Surges in volatility do not signal either the end of a business cycle or an equity bear market. Moreover, while there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two.2 Nonetheless, 60% of volatility upheavals outside of recessions occurred during the late stages of a business cycle. Thus, the recent jump in volatility is another signal that the economy is in the final stages of expansion. Our November 13, 2017 report discussed financial market volatility and its relationship with the business cycle, monetary policy and economic volatility.3 In that report, we noted that any meaningful pickup in inflation would upset the 'low vol' applecart. Prices of U.S. dollar financial assets have recovered since early February's market turbulence, but are not back to pre-spike levels. Chart 2 shows that at 13.7, the VIX is 63% lower than its early February peak. Neither the stock-to-bond ratio (panel 2) nor the S&P 500 (panel 3) has returned to its late January high, but both have bounced up. Small caps (panel 4) have hit a new record, but emerging market equity prices (in U.S. dollars) have languished. The price of West Texas Intermediate oil reached a fresh cycle high in late March and is now above $70 (Chart 3, panel 2). BCA's Commodity & Energy Strategy service expects West Texas to average $70/bbl this year. Moreover, increasing geopolitical risks to supplies (Venezuela and Iran) raise the chances of WTI prices reaching $80/bbl by the end of the year, with Brent prices threatening $90/bbl.4 Our stance on oil prices this year supports more energy-related capex (see next section). Panel 3 shows that despite higher realized inflation and inflation expectations, gold prices have rolled over since the volatility spike. High-yield spreads briefly returned to their late January lows in mid-April, but are now back to the middle of the range that they have been in since early February (panel 4). The dollar has surged in recent months (panel 5). BCA's view is that the dollar will continue to strengthen as the Fed raises rates more than the market expects and as U.S. economic growth outpaces growth outside the U.S.5 Chart 2The VIX And U.S. Financial Assets... Chart 3...Before And After The February Vol Spike Chart 4 shows three-year rolling correlations between several major U.S. asset classes. The early 2018 volatility spike coincided with a shift in the link between the 10-year Treasury yield and the broad dollar (panel 2). The relationship between Treasury yields and oil troughed prior to the spike and continues to climb (panel 4). Otherwise, the longer-term, cross-asset class correlations in place prior to early February are still in play. Chart 4Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations However, shorter-term correlations within the S&P 500 have shifted (Chart 5). The early February volatility run up marked a bottom in the correlation between sectors, industries and individual S&P 500 stocks. This is consistent with what happened in the wake of volatility spikes in 2010 and 2011, but not following the 2015 episode. Bottom Line: The recent vol spike did not signal the end of the expansion or the bull market. Stay long stocks over bonds. Chart 5Intra-S&P 500 Correlations Shifted After The Vol Spike Soundings From The Supply Side BCA expects the U.S. economy to grow above its long-term potential this year and into next year, further reducing slack in both the product and labor markets, and ultimately pushing up inflation. We discussed the housing and consumer sectors in early May6 and this week, we assess business capital spending. Our recent reports7 discussed the near-term benefits to the U.S. economy from higher government spending, but there are supply side benefits as well. The Congressional Budget Office (CBO) boosted its estimate of the economy's long-run potential growth rate due to the supply-side benefits of lower taxes on the labor market and the immediate expensing of capital outlays. Faster growth in the long run would reduce the projected cumulative budget deficit from 2018-2027 by $1 trillion. The CBO also expects that labor force growth will pick up as lower personal income tax rates encourage workers to work longer hours.8 BCA's view is that capital spending was on the upswing before the tax bill passed last year (Chart 6). Moreover, our model for business capital spending suggests gains even without higher oil prices (Chart 7). Chart 8 shows that banks are easing their lending standards for C&I loans (panel 1) and that higher rates have not yet increased the cost of funding to restrictive levels (panel 2). However, demand has been tepid, although it is still trending higher (panel 3). The tax repatriation portion of the 2017 tax cut may have temporarily reduced businesses' demand for loans. Chart 6S&P 500 Sensitive To Oil ##br##Prices And Oil Driven Capex Chart 7Business Spending Poised To Lift Off Chart 8Supply And Demand For C&I Loans Bottom Line: A surge in U.S. capital spending is likely in the second half of 2018 and into 2019. The rising cost of human capital and sagging productivity are additional incentives for firms to spend on labor-saving equipment. Moreover, increased oil prices will drive additional spending in the energy sector. Our U.S. Equity Strategy team recommends an overweight to the Industrials sector.9 While surging capex this year and next will help to boost productivity in the short run, a comprehensive, economy-wide infrastructure package would be helpful in steering the economy away from stagflation in the long run. Stagflation Scenario BCA's 2018 Outlook10 notes that stagflation may be not be present in the U.S. for several more years, likely not until the early 2020s after the next recession. However, BCA's Global Fixed Income Strategy service states that the global economy may be entering a period of mild stagflation characterized by slowing economic growth and rising inflation.11 Nonetheless, some investors are concerned that a prolonged period of stagflation may ensue. We define stagflation as episodes of decelerating real economic growth and accelerating core inflation (Chart 9). Accordingly, stagflation occurred in the 1960s, 1970s and early 1980s. Since then, there have been an additional six episodes, all of them milder than earlier occurrences. The last bout was between July 2015 and October 2016. Chart 9Risk Assets And Stagflation We show the performance of U.S. financial assets, commodities, the dollar and S&P 500 earnings when stagflation was present (Table 1) and when it was not (Table 2). Note that recessions occurred during four of the stagflationary periods (late '60s/early '70s, early-to-mid '70s, late '70s, and late '90s-to-early 2000s). There were two recessions (early 1980s and 2007-2009) when stagflation did not appear. Table 1Risk Assets, Commodities, Gold Oil And The Dollar During Stagflation Table 2Risk Assets, Commodities, Gold Oil And The Dollar When No Stagflation Is Present U.S. stocks, the stock-to-bond ratio, investment-grade credit and high-yield bonds outperform when there is no stagflation. Small cap performance relative to large caps is also better when stagflation is present. Gold (average gain of 85%) and oil (86%) are the standout performers during these cycles. Without stagflation present, gold rises by only 13% on average and oil prices fall by 11%. The dollar climbs by 4% on average without stagflation and declines by 5% when stagflation develops. Restricting our analysis to only the more benign bouts of stagflation in the past 20 years we find similar results; stocks, the stock-to-bond ratio, investment grade and high yield credit perform better when there are bouts of benign stagflation. A notable exception is that there has been little difference in the performance of gold in or out of stagflation in the past two decades. Bottom Line: BCA expects inflation to reach the Fed's 2% target this year and accelerate in 2019, prompting more aggressive central bank actions in mid-2019 through mid-2020 than the market currently prices in. Increased rates will send the economy into recession in 2020. Stagflation will likely take hold as the economy recovers from that recession. Stay overweight stocks versus bonds for now, but look to pare back exposures later this year. Investors with longer time horizons should begin to prepare for lower real returns in the 2020s after the end of the recession early in the decade. Inflation: A Longer-Term View Some investors are concerned that rising deficits will immediately lead to higher inflation. We take a longer-term approach based on our analysis of the link between inflation and federal government interest payments, private credit growth, money supply growth and federal budget deficits. There is only a loose relationship between federal government interest payments as a share of GDP and inflation (Chart 10). For example, interest payments were high relative to GDP in the 1990s, but inflation was low. In the 1970s, inflation was high while interest payments as a share of GDP were not at an extreme. However, there is a strong connection between the growth of private credit and money supply, and inflation. Chart 11 shows that elevated rates for private credit growth are associated with increased inflation and vice versa. High inflation in the 1970s was accompanied by strong credit growth. In this decade, we have experienced meager private credit creation and very low inflation. Chart 12 shows a similar relationship between M2 growth and inflation. Note that strong M2 growth in the 1970s coincided with high inflation, while minimal growth in money supply in the 1930s was accompanied by deflation. On the other hand, there is only a tenuous connection between deficits as a share of GDP and inflation (Chart 13). In the inflationary 1970s, deficits averaged just 2% of GDP. However, the 1950s and 1960s saw both exceedingly low inflation and deficits. So far in the 2010s, deficits have averaged near 5% of GDP, but inflation has been muted at barely over 1%. Chart 10Long Run Relationship Between Federal ##br##Net Interest Payments And Inflation Chart 11Long Run Relationship Between ##br##Private Credit Growth And Inflation Chart 12Long Run Relationship Between ##br##M2 Growth And Inflation Chart 13Long Run Relationship Between Federal ##br##Budget Deficits And Inflation Moreover, the fiscal stimulus put in place late last year and early this year is likely to push inflation higher as it adds to aggregate demand in an economy that is already at full employment. Bottom Line: BCA expects inflation to reach the Fed's 2% target based on the core PCE measure this year, and move above that goal next year, which would drive up both short and long rates. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Serenity Now," published May 15, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Patience Required," published November 13, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Feedback Loop: Spec Positioning & Oil Price Volatility," published May 10, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Swan Songs," published May 18, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Consumer And Housing Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 7 Please see BCA Research's The Bank Credit Analyst, published May 2018 and U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at bca.bcaresearch.com and usis.bcaresearch.com. 8 https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651… 9 Please see BCA Research's U.S. Equity Strategy Weekly Report "Earnings Take Center Stage," published October 2, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's The Bank Credit Analyst "2018 Outlook - Policy And The Markets: On A Collision Course," published November 20, 2017. Available at bca.bcaresearch.com. 11 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Stagflation-ish," published April 18, 2018. Available at gfis.bcaresearch.com.
Highlights The Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation is either too high or too low, and the current account position is either too large or too small. The global economy has made significant progress in moving towards both internal and external balance over the past few years, but shortfalls remain. A number of large economies, including Japan, China, and Italy, continue to need stimulative fiscal policy to prop up domestic demand. In Italy's case, investor unease about the country's fiscal outlook is likely to raise borrowing costs for the government, curb capital inflows into the euro area, and push the ECB in a more dovish direction. All this will weigh on the euro. The U.S. should be tightening fiscal policy at this stage in the cycle. Instead, President Trump has pushed through significant fiscal easing. This is the main reason the 10-year Treasury yield hit a seven-year high this week. An overheated U.S. economy will pave the way for further Fed hikes, which will likely result in a stronger dollar. Rising U.S. rates and a strengthening dollar will hurt emerging markets. Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Feature The Dismal Science, Illustrated Last week's report discussed the market consequences of the tug-of-war that policymakers often face in trying to achieve a variety of economic objectives with a limited set of policy instruments.1 In passing, we mentioned that some of these trade-offs can be depicted using the so-called Swan Diagram, named after Australian economist Trevor Swan. This week's report delves further into this topic by estimating where various economies find themselves inside the Swan Diagram, and what this may mean for their currency, equity, and bond markets. True to the reputation of economics as the dismal science, the Swan Diagram depicts four "zones of economic unhappiness" (Chart 1). Each zone represents a different way in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). This amounts to saying that an economy can suffer from one of the following: 1) high unemployment and an excessively large current account deficit; 2) high inflation and an excessively large current account surplus; 3) high unemployment and an excessively large current account surplus; and 4) high inflation and an excessively large current account deficit. Box 1 describes the logic behind the diagram. Chart 1Four Zones Of Unhappiness BOX 1 The Logic Behind The Swan Diagram As noted in the main text, the Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation are either too high or too low, and the current account balance is either too large or too small. A rightward movement along the horizontal axis can be construed as an easing of fiscal policy, whereas an upward movement along the vertical axis can be thought of as an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule, which corresponds to the ideal state where the economy is at full employment and inflation is stable, is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order to keep the economy from overheating. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. A depreciation of the currency via an easing in monetary policy is necessary to bring imports back down. Any point to the right of the internal balance schedule represents too much inflation; any point to the left represents too much unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Note that according to the Swan Diagram, an economy that suffers from high unemployment may still need a weaker currency even if it already has a current account surplus. Intuitively, this is because a depressed economy suppresses imports, leading to a "stronger" current account balance than would otherwise be the case. We use two variables to estimate the degree to which an economy has diverged from internal balance: core inflation and the output gap (Chart 2). If the output gap is negative, the economy is producing less output than it is capable of. If the output gap is positive, the economy is operating beyond full capacity. All things equal, high core inflation and a large and positive output gap is symptomatic of an economy that is showing signs of overheating. Chart 2The Two Dimensions Of Internal Balance When it comes to estimating the extent to which an economy is deviating from external balance, we include both the current account position and the net international investment position (NIIP) in our calculations (Chart 3). The NIIP is the difference between an economy's external assets and its liabilities. If one were to sum all current account balances into the distant past and adjust for valuation effects, one would end up with the net international investment position. If a country has a positive NIIP, it can run a current account deficit over time by running down its accumulated foreign wealth.2 Chart 3The Two Dimensions Of External Balance Policy And Market Outcomes Within The Swan Diagram Chart 4 shows our estimates of where the main developed and emerging markets fall into the Swan Diagram. The top right quadrant depicts economies that need to tighten both monetary and fiscal policy. The bottom left quadrant depicts economies that need to ease both monetary and fiscal policy. The other two quadrants denote cases where either tighter fiscal/looser monetary policy or looser fiscal/tighter monetary policy are appropriate. In order to gauge progress over time, we attach an arrow to each data point. The base of the arrow shows where the economy was five years ago and the tip shows where it is today. Chart 4Policy Prescription Arising From The Swan Diagram From a market perspective, an economy's currency is likely to weaken if it finds itself in one of the two quadrants requiring easier monetary policy. Among developed economies, the best combination for equities in local-currency terms is usually an easier monetary policy and a looser fiscal policy. That is also the configuration that results in the sharpest steepening of the yield curve. Conversely, the worst outcome for developed market stocks in local-currency terms is tighter monetary policy coupled with fiscal austerity. That is also the policy package that is most likely to result in a flatter yield curve. In dollar terms, a stronger local currency will typically boost returns. This is particularly the case in emerging markets, where stock markets are likely to suffer in situations where the home currency is under pressure. A few observations come to mind: The global economy has made significant progress in restoring internal balance over the past five years. That said, negative output gaps remain in nearly half of the countries in our sample. And even in several cases where output gaps have disappeared, a shortfall in inflation suggests the presence of latent slack that official estimates of excess capacity may be missing. External imbalances have also declined over time. Since earth does not trade with Mars, the global current account balance and net international investment position must always be equal to zero. Nevertheless, the absolute value of current account balances, expressed as a share of global GDP, has fallen by half since 2006 (Chart 5). Chart 5Shrinking Global Imbalances The decline in China's current account balance has played a key role in facilitating the rebalancing of demand across the global economy. The current account showed a deficit in Q1 for the first time in 17 years. While several technical factors exacerbated the decline, the current account will probably register a surplus of only 1% of GDP this year, down from a peak of nearly 10% of GDP in 2007. The Chinese economy also appears to be close to internal balance. However, maintaining full employment has come at the cost of rapid credit growth and a massive quasi-public sector deficit, which the IMF estimates currently stands at over 12% of GDP (Chart 6). Thus, one could argue that a somewhat weaker currency and less credit expansion would be in China's best interest. Similar to China, Japan has been able to reach internal balance only through lax fiscal policy (Chart 7). The lesson here is that economies such as China and Japan which have a surfeit of savings - partly reflecting a very low neutral real rate of interest - would probably be better off with cheaper currencies rather than having to rely on artificial means of propping up demand. Chart 6China's 'Secret' Budget Deficit Chart 7The Cost Of Propping Up Demand Germany has overtaken China as the biggest contributor to current account surpluses in the world. Germany's current account surplus now stands at over 8% of GDP, up from a small deficit in 1999, when the euro came into inception. In contrast to China and Japan, Germany is running a fiscal surplus. Solely from its perspective, Germany would benefit from more fiscal stimulus and a stronger euro. The problem, of course, is that a stronger euro would not be in the best interest of most other euro area economies. While external imbalances within the euro area have decreased markedly over the past decade, they have not gone away (Chart 8). Investors also remain wary of fiscal easing in Southern Europe. This week's spike in Italian bond yields - fueled by speculation that a Five-Star/League government will abandon plans for fiscal consolidation - is a timely reminder that the bond vigilantes are far from dead (Chart 9). The Italian government's borrowing costs are likely to rise over the coming months, which will curb capital inflows into the euro area and push the ECB in a more dovish direction. All this will weigh on the common currency. Chart 8The Euro Club: Imbalances Have Been Decreasing Chart 9Uh Oh Spaghettio! The U.S. is the opposite of Germany. Unlike Germany, it has a large fiscal deficit and a current account deficit. The Swan Diagram says that the U.S. would benefit from tighter fiscal policy and a weaker dollar. President Trump and the Republicans in Congress have other plans, however. They have pushed through large tax cuts and significant spending increases (Chart 10). This will likely prompt the Fed to raise rates more aggressively than the market is currently discounting, leading to a stronger dollar. Chart 10The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Rising U.S. rates and a strengthening dollar will hurt emerging markets, particularly those with current account deficits and negative net international investment positions. High levels of external debt could exacerbate any problems (Chart 11). On that basis, Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Chart 11External Debt And Debt Servicing Across EM Investment Conclusions Chart 12The U.S. Economy Is Doing ##br##Better Than Its Peers The global economy is approaching internal balance, but this may produce some unpleasant side effects. Productivity growth is anaemic and the retirement of baby boomers from the workforce will reduce the pace of labor force growth. In such a setting, potential GDP growth in many countries is likely to remain subpar. If demand growth continues to outstrip supply growth, inflation will rise. Heightened stock market volatility this year has partly been driven by the realization among investors that the Goldilocks environment of above-trend growth and low inflation may not last as long as they had hoped. The U.S. economy has now moved beyond full employment, and bountiful fiscal stimulus could lead to further overheating. This is the main reason the 10-year Treasury yield reached a seven-year high this week. Continued above-trend growth is likely to prompt the Fed to raise rates more than the market expects, which should result in a stronger dollar. The fact that the U.S. economy is outperforming the rest of the world based on economic surprise indices and our leading economic indicators could give the dollar a further lift (Chart 12). A resurgent dollar will help boost competitiveness in developed economies such as Japan and Europe. Emerging markets will also benefit in the long run from cheaper currencies, but if the adjustment happens rapidly, as is often the case, this could exact a short-term toll. For the time being, investors should overweight developed over emerging markets in equity portfolios. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 2 To keep things simple, we assume that a country's Net International Investment Position (NIIP) shrinks to zero over 50 years. Thus, if a country has a positive NIIP of 50% of GDP, we assume that it should target a current account deficit of 1% of GDP; whereas if it has a negative NIIP of 50% of GDP, it should target a current account surplus of 1% of GDP. 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Underweight While we continue to recommend a core portfolio overweight in the S&P financials index, the S&P insurance sub-index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Currently, the U.S. and global economies are expanding above trend and, under such a backdrop, investors have historically avoided insurance equities. The top panel of our chart drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, second panel). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF.
Underweight - Upgrade Alert Homebuilders took another beating this week, and it seems as if they cannot catch a break. While the latest NAHB sentiment survey reflected homebuilder optimism, survey participants acknowledged that spiking building material costs are now hurting profitability (lumber prices shown inverted, middle panel). Tack on the recent jump in the 10-year Treasury yield that also pushed the 30-year fixed mortgage rate significantly higher and first time home buyers are, at the margin, getting priced out of the new home market (interest rates shown inverted, top panel). When we recently put the S&P homebuilding index on upgrade alert, we thought most of the bad news was already priced into deflated prices and valuations. However, persistent input cost inflation pressures coupled with additional interest rate increases suggest that patience is warranted before crystalizing relative gains to the tune of 25% since our late-November inception. Worrisomely, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel). We would lean against such exuberance and wait for another breakdown in relative share prices before acting on our upgrade alert. Bottom Line: Shy away from homebuilders for now, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator Chart I-5China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations