Developed Countries
Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Chart I-17Kiwi Housing Is Expensive It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Chart I-21Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
This week has seen the beleaguered packaged foods index finally catch a bid, driven by exceptional earnings at two of the larger constituents, MDLZ and K. Both highlighted organic volume growth and a better pricing backdrop as the key drivers of top line outperformance. This corroborates with both the overall industry picture (second panel) and our rationale for moving the index to overweight earlier this year (see our Weekly Report of 23 May, 2017 for more details). We continue to expect that a durable top line recovery will expand packaged foods margins. In the context of the significant restructuring the industry has undertaken over the past year and early margin improvements (third panel), packaged foods manufacturers should see outsized earnings growth. Adding on a mouth-watering valuation (bottom panel) makes this index looks particularly appetizing. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, HSY, CAG, SJM, MKC, CPB, HRL.
Overweight We lifted refiners to overweight in mid-September as the pricing environment looked set to improve dramatically, driven by Hurricane Harvey-related refinery shutdowns and the resulting inventory drawdowns, boosted by an accelerating Brent/WTI spread. This view has largely played out as expected; inventories have declined steeply (second panel), the Brent/WTI spread has remained relatively wide (third panel), margins have been grinding higher and the refiners index has been outperforming (first panel). This earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (fourth panel). This should presage stock price strength on the back of strong earnings and a valuation re-rating; stay overweight the refiners index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV.
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of October 31st, 2017. There are no significant changes in country allocations, but minor changes are the reductions in the overweight of Germany, Sweden and Switzerland in favor of Spain and Italy, which were already overweight, and Australia which was underweight, as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 73 bps in October, largely due to the underperformance (110 bps) of Level 2 model, resulting from the large underweight of Japan, which was the best performer in October. The underweight of Australia and Canada worked very well too, but not enough to offset the overweight in the euro zone countries. The strength of the USD against the euro also hurt the performance. Since going live in January 2016, the overall model has outperformed the benchmark by 247 bps, largely from the allocation among the 11 non-U.S. countries, which have outperformed their benchmark by 599 bps. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of October 31st, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The growth component in the model has turned cautious on the global recovery. The aggregate cyclical sector overweight has been reduced to 2.5% from 8% last month. However, cyclical sectors such as energy, materials and industrials have seen an increase in overweight driven by favorable liquidity and momentum backdrop. On the other hand, financials and technology have been downgraded to underweight. Finally, as a result of the bearish outlook from the growth component, the model has turned overweight on utilities. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Duration: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. Municipal Bonds: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Feature Chart 1Discounting An Inflation Rebound In last week's report we pointed out that a flat yield curve is incompatible with core inflation so far below the Fed's target and that the bond market is fast approaching a day of reckoning where either inflation will rise quickly enough to justify the Fed's rate hike expectations, or those expectations will be revised lower.1 Meantime, the Treasury curve has been bear-steepening since early September, and the 37 basis point increase in the 10-year yield has been driven both by higher real yields and a higher cost of inflation compensation (Chart 1). This suggests that the market is pricing-in a rebound in inflation rather than a capitulation from the Fed. Yesterday's PCE inflation report didn't do much to justify those expectations, coming in at only 1.33% year-over-year, not far above the 1.30% reading from August. However, we have previously noted mounting evidence that we are past the worst of the inflation downtrend.2 This raises the question of how much higher Treasury yields can rise, and this is the question we tackle in this week's report. Data Surprises & Playing The Odds Longer run, the 10-year cost of inflation compensation (currently 1.88%) will likely settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's 2% target. Assuming that inflationary pressures are sufficiently strong for that outcome to be achieved with the Fed lifting rates at a pace of about 50 bps per year, then long-dated real yields should stay roughly flat. This means that the nominal 10-year Treasury yield can move another 50-60 bps higher before the end of the cycle. But in the meantime, depending on swings in the macroeconomic data, bonds could experience several playable rallies and sell-offs. Is there a way for us to get a handle on when those might occur? One way might be to examine the economic surprise index (ESI). This index tracks whether economic data are over- or under-shooting consensus expectations. In this way it is very much like a financial market price. It moves higher when the incoming data suggest a rosier outlook than is currently anticipated, but then falls once expectations become so bullish they can no longer be surpassed. This is exactly what happened at the beginning of the year when the 10-year Treasury yield peaked at 2.62% following an extended period of elevated data surprises (Chart 2). Chart 2Economic Surprises Are Mean Reverting More specifically, we observe that when the ESI ends a month above (below) the zero line, it is very likely that the 10-year Treasury yield increased (decreased) during that month (Chart 3). The same is also true for 3-month and 6-month investment horizons, although the correlation is less robust, particularly for values close to zero (Charts 4 & 5). It follows that if we know whether the economic data will surprise on the upside or on the downside in a given month, then we can predict whether Treasury yields will rise or fall. Chart 3Economic Surprise Index & ##br##1-Month Change In Yields Chart 4Economic Surprise Index & ##br##3-Month Change In Yields Chart 5Economic Surprise Index & ##br##6-Month Change In Yields Unfortunately that is not a very profound statement. It is similarly easy to decide how much to bet on a hand of blackjack if you already know what cards will be dealt. But while it is obviously impossible to predict whether data surprises will be positive or negative in a given month, much like a card counter in blackjack, a study of events that have just occurred can help us make inferences that tilt the odds in our favor. In other words, we know that the ESI is mean reverting. A long sequence of elevated readings means it is more likely to fall, and a long sequence of depressed readings means it is more likely to rise. We can even use an AR(3) model to quantify the extent of mean reversion in the index. Using monthly data we run a regression of the ESI on its three most recent lags and get the following result which explains 55% of the variation since 2003: Notice that the index is positively correlated to its reading from the prior month, but negatively correlated with its readings from two and three months ago. Let's now consider that the most recent reading from the ESI is 38.2. One month ago it was -7.9 and two months ago it was -23.1. Using our formula, our best prediction for where the surprise index will be next month is 39. This is still deep in positive territory, meaning that if the model is correct, Treasury yields will remain under upward pressure. More decisively, we conclude from our model that it is unlikely that investor expectations have become so elevated that markets are set up for disappointment. The Appendix to this report provides a reference table for different ranges of the surprise index based on the above formula. It can be used as a quick reference guide for predicting where the ESI is likely to fall next month based on its readings from the prior three months. Bottom Line: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation No Signs Of A Slowdown Last week we learned that GDP grew at an annualized rate of 3.0% in the third quarter, well above the Fed's 1.8% estimate of trend. The number was boosted by strong contributions from inventory accumulation (+0.73%) and net exports (+0.41%), but even stripping out those more volatile components to focus on real final sales to domestic purchasers reveals that growth is firmly above trend (Chart 6). Above-trend GDP growth will ensure that the unemployment rate continues to decline, which in turn will ensure that inflation moves higher. The unemployment rate had come close to flattening off late last year as growth decelerated toward 1.8%, but has since started to fall more rapidly alongside the re-acceleration in GDP (Chart 6, bottom panel). In fact, we attribute this year's decline in inflation to last year's growth deceleration and expect inflation will soon follow GDP growth higher (Chart 7). Chart 6Growth Is Steady, And Well Above Trend Chart 7Inflation Lags Growth Considering the contributions from the more stable sources of growth, we observe the following (Chart 8): Consumer spending remains firm, still above its post-2010 average. Nonresidential investment is accelerating back toward its post-2010 average, following a period of weakness that was driven by the mid-2014 commodity price collapse. Leading capex indicators, such as new orders surveys, suggest the acceleration will continue. Residential investment is a source of concern. It had already decelerated to well below its post-2010 average even prior to the hurricanes that depressed its contribution to growth in Q3. We are not yet concerned that the weakness in residential investment will morph into a broader slowdown. In fact, it appears quite likely that residential investment will bounce back in the coming quarters. Growth in residential investment is correlated with changes in the inventory of outstanding homes (Chart 9). Typically, large slowdowns in residential investment are preceded by a big run-up in supply. But at the moment, supply continues to contract, whether or not we include the shadow inventory from properties that were foreclosed upon during the housing bust. This shadow inventory has mostly evaporated in any case (Chart 9, panel 3). Chart 8Housing Not Keeping Pace Chart 9Inventories Still Falling Further support for residential investment comes from homebuilder sentiment which remains very strong (Chart 9, bottom panel). Bottom Line: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. An Improvement In State & Local Government Balance Sheets Assuming that corporate tax revenues were the same in Q3 as in Q2, we can estimate that state & local government net borrowing declined to $163 billion in the third quarter. This represents a substantial improvement from prior quarters, but one that has already been discounted in Municipal / Treasury (M/T) yield ratios (Chart 10). M/T yield ratios are extremely tight, even compared to average pre-crisis levels (Chart 11), and the unattractive valuation underscores our negative stance on the sector. However, at least for now, there are no signs of an imminent surge in state & local government net borrowing that could cause a credit premium to get priced into muni yields. Chart 10Less Borrowing Is In The Price Chart 11Muni / Treasury Yield Ratios Until last quarter, growth in state & local current expenditures had been running consistently above growth in current revenues (Chart 12). However, the weakness in current revenues was mostly attributable to a slowdown in transfers from the federal government. When we look at growth in state & local government tax revenues only, we find that it is substantially outpacing expenditure growth (Chart 12, panel 2). Chart 12Tax Revenue Growth Greater Than Expenditure Growth The acceleration in transfers from the federal government that started in mid-2014 reflected the expansion of Medicaid under the Affordable Care Act. Now that most eligible individuals have signed up, we would expect growth in federal transfer payments to level-off. Unless legislation is passed to further curb transfers from the federal government, state & local borrowing should continue its decline in the coming quarters. Bottom Line: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Must Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com. Appendix Table 1 Table 2 Table 3 Fixed Income Sector Performance Recommended Portfolio Specification