Developed Countries
Highlights Expect Spain's strong growth to fade somewhat as its credit impulse appears to have peaked. The Catalan independence debate is an inconvenience but not a long term tail-risk. Expect Italy's growth to pick up as the Italian banking system is repaired. Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. France's CAC40 is our preferred mainstream euro area equity market right now. Feature Recent history teaches us that to leave the European Union is inconvenient, but to leave the euro is disastrous. To leave the EU means redefining laws, institutions and trading relationships, but to leave the euro means redenominating the entire banking system's assets and liabilities into different currencies - leading to bank runs and chaotic insolvencies. For this reason, even tiny Greece chose to suffer an extended depression rather than to leave the euro. Chart of the WeekSpain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Leaving The EU Is Inconvenient, Leaving The Euro Is Disastrous To leave the EU, there is a broadly defined process but the process is inconvenient and protracted, as the United Kingdom is now discovering. The U.K. will technically leave the EU on March 31 2019, but Prime Minister May has proposed a further transition period of "around two years." Therefore the U.K. will remain in the European single market and customs union - and fully subject to EU laws and regulations - until at least 2021, five years after the U.K. voted to leave the EU. This protraction of the exit process creates a tasty irony. Not long after the U.K. fully leaves in 2021, the Leave vote's 1.25 million majority will have disappeared - counting those who voted in 2016 who are still alive. This is because out of the 0.625 million deaths in the U.K. in each of the coming years, there is a very heavy skew to Leave's much older voters1 (Chart I-2). As the U.K is not in the euro there is no secondary issue of whether to leave the single currency. But this does raise an interesting hypothetical question. If a euro area country - or region like Catalonia - inconveniently left or was ejected from the EU, does it follow that it must also crash out of the euro? No. Several non-EU countries already use the euro. There are the European microstates of Andorra, Monaco, San Marino and Vatican City. More significantly, Montenegro and Kosovo have adopted the euro as their de facto currency. To be clear, we do not expect Catalonia to secede. Polls consistently show a significant majority in Catalonia do not want full independence (Chart I-3). The unionists mostly boycotted the independence referendum because Madrid deemed it illegal. Given the low turnout, the 89% vote for independence equalled just 37% of eligible voters. Chart I-2The Vote For Brexit Was ##br##Driven By Older Voters Chart I-3A Significant Minority In Catalonia##br## Do Not Want Full Independence But even if Catalonia did become independent, this hypothetical eventuality would not involve a catastrophic exit from the euro. Catalonia, in its economic interest, would want to keep the euro, and the EU would let it. The Spain/Italy Conundrum The much bigger threat would be if a major euro area country felt that the single currency was not in its economic interest, and decided to jettison the euro. In this regard, the problem - at first sight - appears to be Italy. Through the 19 years of the euro, Italy's real GDP per head has grown by just 6%, substantially less than any other major economy. If the single currency is to blame for the significant underperformance of its third largest economy with 60 million people, then the euro's long-term viability has to be in question. But it is hard to blame the euro per se for Italy's painful underperformance. For the first half of the euro's life, 1999-2007, Italian real GDP per head performed more or less in line with the United States, Canada and France (Chart I-4) - even without a substantial tailwind from a credit-fuelled boom which the other economies had. Then, in the post-2007 years, there was little to distinguish the economic performances of Italy and Spain until 2013 (Chart I-5). At which point, Spain took off, with real GDP per head subsequently expanding by 15%. Whereas Italy struggled to grow. The conundrum is: what explains this stark recent difference between Spain and Italy? Chart I-4Through 1999-2007, Italy Grew In Line ##br##With Other Major Economies Chart I-5Post-Crisis, There Was Little To Distinguish##br## Italy and Spain Until 2013 The start of Italy's underperformance in 2008 and the start of Spain's strong recovery in 2013 provide the solution to the conundrum. Following the global financial crisis in 2008, Italy has still to repair its banking system. Whereas Spain fixed its banks in 2013. Significantly, Spain ring-fenced bad assets within a bad bank while recapitalising good banks. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. Therefore in 2013, Spanish banks' aggressive deleveraging ended. The result was that Spain's credit impulse - which measures the change in bank credit flows - rebounded very sharply and has remained positive for four years. This explains Spain's remarkably strong recovery (Chart I-6). In contrast, Italy's still dysfunctional banking system means that its own credit impulse has been much more muted and barely positive over the past four years (Chart I-7). Begging the question: why has Italy been so slow to fix its dysfunctional banking system? One reason is that Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the credit booms in the U.S., U.K., Ireland and Spain did eventually cause housing busts and full-blown banking crises, requiring urgent policymaker response. A second reason is that the Italian government is more highly indebted than other governments, making it more difficult to raise public funds to fix the banking system. The good news is that the Italian government, the EU and the ECB are now on the same page and finally progressing to repair the banking system. Italian banks' equity capital is rising (Chart I-8), their solvency is improving, and the share of non-performing loans has fallen sharply this year (Chart of the Week). Chart I-6Spain's Credit Impulse Rebounded Sharply Chart I-7Italy's Credit Impulse Has Been More Muted Chart I-8Italian Banks Are Raising Equity Capital Moreover, the recent smooth winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the EU's new rules for resolving failing banks is working. Admittedly, the rules mean that institutional investors could still suffer losses. But a pragmatic solution will permit public funds to protect 'widows and orphans' retail investors. Some Investment Thoughts As the Italian banking system is repaired, there will be a pickup in Italy's growth just as there was in Spain. However, the strong tailwind to Spain's growth that started in 2013 is now fading given that Spain's credit impulse has peaked. This suggests that the yield spread between Italian BTPs and Spanish Bonos - which measures the extra risk premium in Italy - is at a cyclical peak from which it is likely to compress (Chart I-9). Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. On the face of it, a fading risk of euro breakup should also boost euro area equity relative performance. The trouble is that the relative performance of the broad Eurostoxx50 index is entirely at the mercy of its major sector skews - specifically, a huge underweighting to Technology and an overweighting to Banks (Chart I-10). The way around this dilemma - to like euro area equities but to dislike the overall sector skew - is to steer towards mainstream indexes which have less of a distorting skew. On this basis, the mainstream euro area equity market we would pick right now is France's CAC40 (Chart I-11). Chart I-9The Yield Spread Between Italian And ##br##Spanish Bonds Is At A Cyclical Peak Chart I-10Eurostoxx50 Relative Performance Is ##br##At The Mercy Of Its Sector Skews Chart I-11Prefer the CAC40 To##br## The Eurostoxx50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the U.K. around 625,000 people die every year and the vast majority of these are aged over 65. But in this older age cohort, 64% voted Leave (source: YouGov). So we can infer that of the 625,000 deaths, about 400,000 voted Leave and 225,000 voted Remain, eroding the Leave majority who are still alive by 175,000 every year. Fractal Trading Model This week, we note that the Canadian 10-year government bond is oversold and due a trend reversal. We prefer to express this as a new relative trade: long Canadian 10-year bond / short 10-year German bund with a profit target / stop-loss of 1% and double position size. In other trades, long USD/CAD hit its 2.5% profit target - the second success in this specific trade in the last three months. We now have three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Weak spots in the U.S. economy have become increasingly hard to find. That said, two standouts are non-residential construction and light vehicle production, both of which remain in contraction despite the overall economic expansion (second panel). Importantly, growth in both of these sectors relies heavily on expanding credit; in the most recent Fed senior loan officer survey, these categories both saw tightening lending standards, implying a negative credit impulse (third panel). All of this is bad news for domestic steel producers, for whom non-residential construction and light vehicle production are the key end markets. Even worse news is that steel imports are gaining share of an increasingly diminished market (fourth panel), despite the Trump administration's pledge to protect domestic steel production through tariffs. Iron ore prices in China, which have struggled to climb off lows (bottom panel), imply that tariffs will need to be substantial to stem foreign inflows. Bottom Line: Weak demand, policy uncertainty and increasing offshore competition should sustain downward pressure on steel stocks. Stay underweight. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL - NUE, STLD, RS, X, ATI, CRS, CMC, WOR, AKS, TMST, SXC, HAYN, ZEUS.
Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Catalonia is a red herring - stay focused on U.S. tax cuts; Tax cuts are on track and will swell the budget deficit; The dollar is poised for a comeback; Believe the Phillips Curve, not the "Amazon effect"; Shinzo Abe's gamble is bullish; go long USD/JPY. Feature Global investors woke up on Monday to shocking news of a mass shooting in Las Vegas and police brutality in Catalonia, where Spain's federal law enforcement attempted to break up the October 1 independence referendum. According to final figures, nearly 92% of those who voted chose to separate from Spain, setting the stage for a unilateral declaration of independence. Our views on the Catalan independence "struggle" are well known to our clients.1 We will only briefly recap them here. Instead, we focus this Weekly Report on the prospects for the U.S. dollar and on Japan's snap election. Catalan Independence: Indignation Is Not A Strategy Why are we so dismissive of the imbroglio in Catalonia? Five reasons: Police "brutality" is overstated: Catalan officials reported that 844 people had been hurt in clashes, but the BBC noted that the "majority had minor injuries or had suffered from anxiety attacks."2 Not the first referendum: The turnout was only 42.34%, as many voters refused to participate. Given that the latest polls show that only 34.7% of Catalans actually want independence, the result was unsurprising (Chart 1).3 Those who oppose independence from Spain stayed home, as they did in 2014. In fact, Table 1 shows that there were about 100,000 less "yes" voters in 2017 than three years ago. Catalonia is not Catalan: According to the latest data from the Institut d'Estadística de Catalunya, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish. This is a product of decades of migration from within Spain which has diluted Catalonia's homogeneity. For the most part, the non-Catalans belong to the working class and do not get involved in independence protests or in breathlessly tweeting about the return of dictatorship to Madrid. But if they sense that independence is being imposed on them by an elitist minority, they could let their voice be heard. A declaration of independence means nothing: A unilateral declaration without international support, or the ability to enforce it with arms, is vacuous. U.S. President Donald Trump lent his support to Spanish Prime Minister Mariano Rajoy ahead of the vote, while French President Emmanuel Macron reiterated his support for Madrid following the referendum violence. The EU has made it clear that an independent Catalonia would have to go through the accession process in order to enter the EU, which means it would not have access to the Common Market post-independence. Catalans will not resort to force en masse: Our expectation is that Catalans will not resort to force in order to breakaway from Spain. German sociologist Max Weber famously defined sovereignty as a "monopoly over the use of legitimate force" in a defined geographical territory. If a Catalan minority is unwilling to wrestle control of borders from Spain, its declarations will be irrelevant. Chart 1Catalonia: A Revolt By The Minority Table 1What Has Changed Since 2014? There is more to the referendum than the government in Catalonia is letting on. The Junts pel Sí (Together for Yes) coalition of four parties is unified only by its stance on independence. But the main two nationalist parties that make up the government are on the opposite sides of the ideological spectrum. Without the independence push, the regional government would lose its raison d'être and fall. From the market perspective, the situation in Catalonia would become relevant if the Catalan government, or militant groups in the region, decided to step up tensions by employing force. This could derail Spain's economic recovery, especially since so much of it was centered on manufacturing in the region. We do not see this as likely. First, there are no "militant groups" in Catalonia. Second, throughout the half-century long Basque conflict - which saw over thousand people killed between 1959 and 2011 - Catalonia never experienced violent unrest. Catalan extremists never got inspired by the militant Basque group ETA on any significant scale. Why? Because the independence movement in Catalonia is mainly a bourgeois, middle and upper class, "struggle" for independence that is unlikely to descend into violence. Yes, there are some farmers and blue-collar supporters of independence. But the majority of Catalonia's working class are actually not Catalan. They are either recent migrants from the rest of Europe or migrants from poorer regions of Spain. Not only are they opposed to independence, but they are openly hostile to a bourgeois minority lording their Catalan ethnic superiority over the recently arrived migrants. With Catalan tensions, the ongoing North Korean saga, and the recent tragedy in Las Vegas, there is plenty to distract investors from the most investment-relevant political issue: U.S. tax policy. Bottom Line: As we noted in February, European assets will continue to "climb the wall of worry," which includes Catalan tensions.4 Investors should fade any market reaction to the crisis in Catalonia, which is sure to dominate the news flow for at least the entirety of Q4 2017. Do Republican Voters Want Tax Cuts? The market was shocked at the end of September by President Donald Trump's tax reform plan. After months of doubting whether Republican policymakers can accomplish anything, the market reacted positively to the announcement (Chart 2). And yet a lot of skepticism remains. Primarily, the fear is that fiscally conservative Republicans in the House and Senate will stand in opposition to the plan. After all, Republicans have just failed to repeal and replace Obamacare. Why should tax policy be any different? Chart 2Sign Of Life For 'Trump Reflation' We have argued since November that Republicans in Congress are actually not fiscally responsible.5 Not now and not ever. As if on cue, this spring, the leader of the Tea Party-linked Freedom Caucus, Mark Meadows (R, NC) said that the upcoming tax reform effort did not have to be "revenue-neutral," a claim he repeated on NBC's Meet The Press this weekend. If the leader of the single-most fiscally conservative grouping in Congress is okay with profligacy, who is left to oppose it?!6 Republican voters might have something to say about deficit-busting tax legislation. But GOP legislators are not the only ones willing to compromise on their austerity rhetoric. Republican voters are just as comfortable with profligacy. Chart 3 speaks volumes. It shows that Americans become a lot more comfortable with a bigger government providing more services when Republican presidents are in power. Given Democrats' stable preference for more spending, the movement in the poll is mainly due to Republican and independent voters. There are two ways to interpret the data: Republican voters do not mind a profligate government, as long as the spending is aligned with their priorities. Republican voters do not actually disagree with Democrats on spending priorities, but merely doubt that Democratic policymakers can deliver on those priorities in a fiscally sustainable manner. Whatever the explanation, Chart 3 is clear evidence that the American public grows more comfortable with profligacy when Republicans are in charge. But do voters want tax cuts? The latest polls show that Americans no longer think that they pay too much in taxes (Chart 4). Republican and Republican-leaning voters do not have a problem with how much they pay in taxes, but they do have a problem with the complexity of the tax code (Chart 5). Chart 4American Voters Think Taxes Are Fair... Chart 5...But Republican Voters Think They Are Too Complex The charge that the Trump tax legislation will be a massive tax cut for the wealthy and corporations could stick with some voters, we think primarily with Democrats. Pew research polling consistently shows that Democrats, across the income brackets, agree by 70%-80% that corporations and wealthy people pay too little tax. Republican voters could be susceptible to the same argument, given that around 35%-45% of them agree with Democrats on this issue. To preempt the debate, the Trump administration is focusing heavily on tax complexity. In addition, Trump left the proposed surcharge on the wealthy - a fourth income bracket in the new plan - as yet undefined. This is on purpose. It allows the White House and Congressional GOP legislators to respond to the criticism as it develops. What could be the stumbling blocks going forward? A "Breitbart clique" revolt: A populist revolt against tax cuts for the rich could turn skittish Republicans in Congress against the legislation. The recent electoral defeat for the political establishment in the Alabama Senate primary has shown off the power of the "Breitbart clique" in itself, independent of Trump. However, a quick survey of Breitbart.com shows that the former White House Chief Strategist and Rabble-Rouser-in-Chief Steve Bannon has not unleashed his media machine against the tax plan. In fact, the only prominent Breitbart piece on the tax plan thus far has excoriated the mainstream media for misinterpreting the comments of Gary Cohn, the White House's chief economic adviser, on middle class tax cuts.7 It may be the first time that the website has ever written anything positive about Cohn. Blue State Republicans: There are 29 Republican representatives facing tough reelection campaigns next year who are based in states that voted for Secretary Hillary Clinton in 2016. These Republican representatives will staunchly oppose any proposal to end the state and local tax deduction, given that their voters will be subjected to higher rates of state and local taxes.8 These "Blue State Republicans" could scuttle the current tax blueprint in the House. Anticipating the problem, Gary Cohn has said that the removal of the deduction is not a "red line" for the administration. Senators: Republicans have only a slim margin for error in the Senate. Senators Bob Corker (R, TN) and John McCain (R, AZ) could be the two staunchest opponents to the tax reform effort. The former is a deficit hawk and critic of the president, the latter is a maverick and firmly opposed to the president. On the other hand, the usual thorn in the side of the GOP establishment, Rand Paul (R, KY), could be brought around to support the proposal. Moderates like Susan Collins (R, ME) and Lisa Murkowski (R, AK) should be watched carefully. Investors should expect more Republicans to come out in opposition to certain provisions of the proposed tax legislation. However, the path of least resistance is not for the entire effort to fail, but rather for it to become more profligate. For example, the White House has already gestured towards a compromise with Blue State Republicans on the state and local tax deduction that would increase the deficit. Furthermore, we continue to stress that the failure of the Obamacare repeal and replace bill is not a good guide for what will happen with tax legislation. Taking away an entitlement program is politically challenging. Tax cuts, on the other hand, are generally not. Bottom Line: President Donald Trump is an economic populist. Our research into international comparisons shows that populists tend to get what they want, which is primarily higher nominal GDP growth (Chart 6). We therefore continue to expect the roughly $1.5 trillion tax cut effort - which may or may not deserve the title of tax reform - to pass. Is King Dollar Primed For A Rally? Investors should consider the proposed tax legislation a form of modest stimulus. If we assume that the $1.5 trillion in tax cuts will be offset with a combination of revenue-raising policies to the tune of 50%, it still leaves roughly $750 billion in new deficit spending (stimulus) over the next ten years. A more reasonable figure for total revenue offsets is around $400 billion, which would put the cost of stimulus at roughly $1.1 billion.9 This is not extraordinary large, but even a modest effort this far into the economic cycle could have a significant effect. BCA's Chief Global Strategist, Peter Berezin, believes that inflation is around the corner.10 So why the delay in the data? Peter points out that while the Phillips Curve has gotten a lot flatter over the past four decades (Chart 7), it remains a curve. Once the economy reaches full employment - as it has done in the U.S. (Chart 8) - the curve steepens much faster. As Peter puts it: Chart 6Populists Deliver (Nominal) GDP Growth Chart 7The Phillips Curve Has Gotten Flatter Chart 8U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 9 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-5%. Chart 9Watch Out For The 'Kink' In The Phillips Curve When we present Peter's argument to clients, many retort that "this time is different," namely because of phenomena like the "Amazon effect." To put that argument to rest, our colleague Mark McClellan has penned a Special Report titled, "Did Amazon Kill The Phillips Curve?"11 Mark shows that while e-commerce is undoubtedly increasing its share of retail sales (Chart 10), its contribution to annual headline CPI is modest. For example, Chart 11 shows that online prices fell relative to the overall CPI for most of the time since the early 1990s. However, e-commerce only contributed about -0.15 percentage points to annual CPI in June 2017, and has never contributed more than -0.3 percentage points. Chart 10E-Commerce: Steady Increase In Market Share Chart 11Online Price Index To further test the impact of e-commerce on inflation, Mark focused on the parts of the CPI that are most exposed to it. If online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. He therefore combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure (Chart 12). Again, the contribution of e-commerce-heavy sectors to annual CPI is minimal. Chart 12Electronic Shopping Price Index Chart 13BCA E-Commerce Proxy Price Index Chart 14BCA E-Commerce Adjusted Proxy Price Index Mark finally recalculated the e-commerce proxy using only the sectors displaying the most relative price declines - clothing, computers, electronics, furniture, sporting goods, air travel, and other goods - and assumed that all other sectors actually deflated at the average pace of the entire index. The adjusted e-commerce proxy suggests that online pricing reduced overall CPI by about 0.1-0.2 percentage points in recent years (Chart 13 & Chart 14). We find Mark's work intuitive. The "Amazon effect" is a great example of fitting a broad theory to a particular set of data, a common error in the investment community. The weak inflation print - which is a "Summer of 2017" phenomenon - is being extrapolated into a decade-long theme. But the data is clear: the deceleration of inflation since the Great Financial Crisis has been in areas unaffected by online sales, chiefly energy, food, and shelter costs. High corporate profit margins in the retail sector also argue against the idea that e-commerce represents a large positive macro supply shock. In fact, today's creative destruction in retail may be no more deflationary than the shift to "big box" stores in the 1990s. Putting it all together, the three above views provide a fairly clear signal in terms of asset implications: Geopolitical Strategy Tax Policy View: Tax legislation is a form of modest stimulus enacted by a populist White House in search of higher nominal GDP growth, and it will pass; Global Investment Strategy Phillips Curve View: The Phillips Curve is not dead, just dormant, and will steepen as the U.S. unemployment rate declines further below the equilibrium level; The Bank Credit Analyst "Amazon Effect" View: There is no "Amazon Effect." Pro-cyclical fiscal stimulus in the U.S. should be bullish for the U.S. dollar, bullish for U.S. small caps relative to large caps, and bearish for U.S. 10-year Treasuries. We are already long USD against EUR by recommending that our clients go long Euro Area equities relative to the S&P 500 with a currency hedge.12 We think there may be more upside for the USD against the yen, especially given our view of the upcoming general election in Japan below. What are the risks to a bullish USD view? Continued strong global growth is the main risk (Chart 15). Global data is improving to the point that even moribund Italy is now on fire (Chart 16). However, the positive data may be peaking. European data, in particular, looks like it is reaching its absolute highs (Chart 17). Chart 15Can Global Growth Get Any Higher? Chart 16Italy Is On Fire... Chart 17...As Is Europe Overall Particularly concerning from the global perspective is the ongoing slowdown in the pace of expansion of Chinese money and credit, which we have been arguing for almost a year is policy induced.13 Our colleague Arthur Budaghyan, Chief Strategist of BCA's Emerging Market Strategy has flagged that the official M2, as well as BCA's own custom version of broad money M3, are slowing down to new lows (Chart 18). From the broad money M3, Arthur and his team construct the M3 impulse, which leads both the Chinese leading economic indicator and the well-known "Li Keqiang index" (a growth proxy) by six months (Chart 19).14 Most importantly from the global perspective, the slowdown in Chinese money and credit growth ought to negatively impact demand for imports from China-exposed export sectors in Asia and Europe (Chart 20). Chart 18But Credit Growth In China Is Slowing Chart 19Chinese Credit Leads The Domestic Economy... Chart 20...As Well As Exports To China The policy-induced crackdown against money and credit growth in China should be particularly pertinent in Europe. BCA's Foreign Exchange Strategy has noted how the close trading relationship between China and Europe influences the growth delta between Europe and the U.S.15 Given the potential slowdown in China, and subsequent impact on EM economies, bullishness on Europe could be peaking. Bottom Line: Our view that a modest fiscal stimulus may be afoot is only a small part of a wider BCA bullish-USD narrative. We think it is once again time to turn bullish towards the greenback. We are opening a long USD/JPY recommendation. Our colleague Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, has been long since USD/JPY hit 109 on August 11. Japan: Abenomics Will Survive Abe Japanese Prime Minister Shinzo Abe's snap election on October 22 took us by surprise. Not because of the timing, which was telegraphed by rumors in the press, but because, for Abe and the ruling Liberal Democratic Party (LDP), the upside risk is limited while the downside is unlimited. Since May 24 we have argued that Abe's political capital has peaked, based on the empirically grounded expectation that his pursuit of constitutional changes to legitimize Japan's defense forces would erode his popular support.16 This view received confirmation in early July, when Yuriko Koike, a former LDP politician, led an insurgency against the LDP in the Tokyo metropolitan elections and dealt them a historic blow in that region. At that time, we argued that Abe would not lose power anytime soon: he maintained his two-thirds supermajority in the lower house (and virtual supermajority in the upper house), did not face an election until December 2018, and could thus double down on reflationary economic policies in order to rebuild popular support.17 Chart 21An Upstart Party Challenges The LDP Now, Abe has made a risky decision to move the general election forward 14 months. He wants to capitalize on Japan's recent strong economic performance, the peaking of North Korean tensions (which are likely to decline by late next year), and an uptick in approval ratings. Last but not least, he wants to take the fight to the political opposition at a time when the rival Democratic Party is in total collapse and Governor Koike, his chief antagonist, is unready to wage a national campaign. The timing was shrewd but comes at a cost. Koike announced a new political party, the Party of Hope, just hours before Abe called the early election. In the first set of opinion polls it has sprung up to 15% approval, only nine points shy of the LDP. True, this is still 14 points short of the ruling coalition (Chart 21). But crucially, the collapse of the Democratic Party prompted its leader, Seiji Maehara, to declare that his party would not contest the new elections. This leaves its members free to join Koike's party; it also partly obviates the problem of the Democratic Party and Party of Hope stealing each other's votes.18 Throughout Abe's term we have compared his approval ratings to those of former Prime Minister Junichiro Koizumi, the LDP's last heavyweight leader, to test whether he retains political capital (Chart 22). According to this measure, he does. Yet, given Abe's long tenure and gradually declining support, this comparison only works as long as there is no viable alternative. That is because Abe's net approval rating, as well as his ability to bring star-power to the LDP, has been fading in recent years (Chart 23). Now he has called an election at the very moment that a possible alternative has emerged!19 Chart 22Abe Losing Favor Over Time Chart 23Abe Becoming A Liability However, we say a possible alternative for a reason: Koike herself, as yet, is refusing to run for the prime minister's slot. She is in a "dilemma of irresponsibility" in which, having just become governor of Tokyo on the pledge to put "Tokyo First," she will be criticized for flagrant ambition and flip-flopping if she abandons that post to run against Abe directly.20 As long as Koike remains on the sidelines, Abe will retain his absolute majority. It would be very difficult for a new party that is struggling to field candidates across the whole country, lacks a clear prime minister candidate, and faces competition with other opposition parties to deprive an incumbent coalition of 85 seats. (Depriving the LDP of its 50-seat party majority alone would be momentous, though conceivable.) The LDP has fallen out of power on only two previous occasions since 1955: once, briefly, in 1993, in the wake of the collapse of Japan's Heisei bubble, and once in 2009, in the wake of the global financial crisis (Chart 24). And the LDP has never lost more than 22 seats in an election year, like this year, in which economic growth is faster than the preceding year. That size of loss would leave Abe wounded but still in control.21 Chart 24The LDP Seldom Loses Elections In Japan On the other hand, if Koike changes her mind and throws herself headlong into competition with Abe, it is possible, albeit still highly unlikely, that she could pull off a historic upset.22 Currently the number of undecided voters is high at about 43%. In recent years, these voters have tended to correlate negatively with LDP support (Chart 25), meaning that LDP voters grew dissatisfied and "undecided" but then came crawling back when the party wooed them. However, Koike could change this dynamic - not only because she apparently has momentum, but also because her background and platform are substantially similar to Abe's, yet with a fresh face.23 Chart 25Undecided Voters Often Return To LDP Koike must make her decision by October 10. It is unlikely that she will join or that her party will field enough competitive candidates - in this respect, Abe gambled correctly in calling the election now. Barring her entrance, what is at stake is Abe's 6-seat "supermajority" in the lower house. Abe is likely to lose this advantage simply based on the Party of Hope's strength in Greater Tokyo and the Kanto Plain, augmented as it is by collaboration with the Democratic Party. A back-of-the-envelope calculation suggests that Koike could easily deprive Abe of this supermajority. Assuming that the Party of Hope performs in line with Koike's performance in the Tokyo/Kanto region in July, gaining 39% of the seats (34% of the popular vote), implies that the Party of Hope could steal as many as 47 seats from the ruling coalition on October 22 (Table 2). This is a generous estimate in giving Koike's party strong support, but a conservative estimate in assuming that it will not win a single seat outside the Tokyo/Kanto region.24 Losing this supermajority would be a big loss of momentum for Abe and the LDP that would carry over into the legislative process (where Abe would struggle to control the LDP factions and fend off corruption allegations) and future elections (where the LDP would be more vulnerable). It would sow the seeds for a leadership challenge against Abe in the LDP next September. But it keeps the LDP in power for the next four years. And its direct impact on passing bills is limited. A lower house majority would still be under the LDP leader's control, and the LDP would still have a near-supermajority in the upper house, removing any risk that it would delay bills. The only initiative likely to suffer would be Abe's treasured constitutional revisions, and yet even those would still have a fighting chance of passing the Diet. The important thing for investors to realize is that a setback or defeat for Abe will not be the death of Abenomics.25 Reflation will continue and Japanese risk assets will continue to outperform on a currency-hedged basis. Why? Table 2The Party Of Hope Threatens The LDP Supermajority From Its Base In The Tokyo/Kanto Region Abenomics is already bearing fruit: Inflation remains weak, but Japan's output gap is closing and unemployment gap is gone (Chart 26). It is only a matter of time before supply constraints put more upward pressure on prices, lowering real rates and easing financial conditions for the economy as a whole. Koike, who styles herself as a pro-business Thatcherite, will not stand in the way of growth. Monetary policy will remain dovish: The dovish shift in the Bank of Japan in 2013 was a regime change within the institution itself. Governor Haruhiko Kuroda was the leader of the change, but since then the entire policy board has been staffed with doves. In fact, in the board's recent minutes, the only dissenting voice argued for more stimulus.26 Kuroda can legally be reappointed for governor for another five years. If not, his replacement will likely perpetuate his legacy, as neither Abe nor Koike have given any hint at wanting more hawkish monetary policy. The market is right to expect barely any rate hikes over the next year and for the BoJ to continue suppressing yields even as other DM central banks become more hawkish (Chart 27). Chart 26Tight Labor Market, But Still No Inflation Chart 27Monetary Policy Will Remain Easy Fiscal policy will ease further: We have shown Chart 28 again and again to clients: the main failure of Abenomics so far has been Abe's own fiscal responsibility. Upon calling the election, he yet again pitched himself to voters on the basis of fiscal irresponsibility. He offered a new 2 trillion yen stimulus package and suspended his pledge to balance the budget by 2020. And while he pledged to pay for education and elderly care by raising the consumption tax from 8% to 10% as scheduled in October 2019, few doubt that he will delay a tax hike (as in 2015) if it threatens to upset his economic recovery. Meanwhile, Koike is running on a platform of easier fiscal policy: she has outright opposed the consumer tax hike, saying that to do so would be to "throw cold water on the still-intangible economic recovery." She wants more earthquake-resistant infrastructure and more social spending (e.g. childcare). She wants measures to boost the female participation rate further (Chart 29).She is hardly likely to boost consumption without continuing Abe's quest to lift wages overall (Chart 30). And in her most significant difference from Abe, she hopes to do away with nuclear power and turn Japan into a renewable energy powerhouse (inevitably requiring large-scale government subsidies and investment). Foreign policy will remain hawkish: Koike is a conservative who is in favor of constitutional revisions to normalize Japan's military. Her Party of Hope could even vote with the LDP on this issue, for a price. While it may be somewhat more China-friendly than Abe (possibly a boon for exports), it would not be willing or able to break Japan's recent trend of rising defense spending and economic diplomacy. Chart 28Fiscal Policy Will Get Easier Chart 29Abe And Koike Want Women Workers Chart 30Abe And Koike Want Higher Wages Moreover, given that Japan has a much higher ratio of public investment to private investment than other comparable countries, and that fiscal spending is limited by a massive debt load, Koike would be committed to boosting private investment just like Abe (Chart 31). Indeed, judging solely by key policy planks, the Party of Hope could almost become an LDP coalition partner. It cannot win a majority without Koike as frontrunner, and even if it did, it would lead to a fractious parliament where it would be forced to cooperate with the LDP in order to pass bills through the LDP-dominated upper house. Koike's sudden emergence does not represent a shift in national trends but rather a confirmation of the post-2011 Japanese political consensus in favor of a dovish central bank, dovish fiscal policy, and hawkish foreign policy. Chart 31Abe And Koike Want Private Investment Chart 32Not Abandoning Nuclear Power Anytime Soon Bottom Line: As things stand, Abe will probably lose his supermajority yet retain his majority in the lower house. This will cause some volatility and policy uncertainty in Japan. Nevertheless, the outlook is still highly reflationary. Koike reveals that the median voter favors pushing Abenomics even further. Should Koike make a dash for the prime minister's slot, she does have a small chance of coming to power. It is hard to put a probability on it until more polling data is available. The biggest policy consequence of a Party of Hope-led government would be her energy agenda of weaning Japan off of nuclear power, which would in the first instance shrink the current account surplus, as during the nuclear shutdown following the Tohoku earthquake in 2011 (Chart 32). However, a Koike majority is unlikely to materialize as things stand, and the LDP in the upper house would be a check on such policies. Go long USD/JPY in expectation of more reflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, and BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 2 Please see BBC, "Catalan referendum: Catalonia has 'won right to statehood,'" dated October 2, 2017, available at bbc.com. 3 We are referencing poll numbers collected by the Centre d'Estudis d'Opinió, which is run by the pro-independence government of Catalonia. In other words, if biased, the polls should be biased towards independence. 4 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 6 Apparently, the Democrats! Democratic leaders in Congress oppose tax reform policy that is not revenue-neutral. However, the GOP can ignore them as they plan to use the reconciliation procedure to pass tax policy. 7 Please see John Carney, "Mainstream Media Distort Every Single Thing Gary Cohn Says About GOP Tax Plan," dated September 30, 2017, available at breitbart.com. 8 The announced tax reform plan does not include such a proposal - nor does it provide any detail on how tax cuts would be paid for - but it has been floated as a possibility. This is because it could save the government nearly $370 billion by 2020, according to a report from the congressional Joint Committee on Taxation. 9 For revenue offsets that are likely to pass, we combine the repatriation of foreign earnings ($138 billion over the next decade), the repeal of certain corporate tax breaks ($138 billion), and the repeal of certain individual tax expenditures ($385 billion). We roughly estimate that the offset would total $400 billion, as horse-trading in Congress is likely to reduce the eventual size of overall revenue-offsets. The path of least resistance in Congress is towards more deficit spending, not less. 10 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com. 11 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017, available at bca.bcaresearch.com. 12 We recently closed our recommendation of being long Euro Area equities relative to the U.S. in an unhedged position for a 7.88% gain. 13 Please see "China: Xi Is A 'Core' Leader ... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016; "China: How Far Will Deleveraging Go?" in Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017; and Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 14 Please see BCA Emerging Market Strategy Weekly Report, "Copper Versus Money/Credit In China - Which One Is Right?" dated September 6, 2017, available at ems.bcaresearch.com. 15 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 18 The problem still partially exists, as the opposition remains divided by various parties, and left-wing members of the Democratic Party have formed a new Constitutional Democratic Party of Japan that will contest the election and compete with the Party of Hope as well as the ruling LDP. 19 Incidentally, she is one of Koizumi's disciples who can count on his support. 20 According to Shinjiro Koizumi, "If she runs it's irresponsible, if she doesn't run it's irresponsible ... she's in a 'dilemma of irresponsibility.'" Quoted in Robin Harding, "Yuriko Koike hits trouble in Japan election campaign," Financial Times, October 2, 2017, available at www.ft.com. 21 The 22-seat loss referred to above occurred under the leadership of Takeo Miki in 1976. 22 There have been only two occasions in which a multi-term prime minister like Abe lost power due to holding a general election - 1960 and 1972. In the latter, comparable case, Eisaku Sato, who had been in power for eight years, lost power despite the fact that economic growth had recovered from a slight slowdown in 1971. In other words, the lack of enthusiasm for Abe amid a recovering economy is an important warning sign, which we discussed in BCA Geopolitical Strategy Weekly Report, "Insights From The Road - Asia," dated August 30, 2017, available at gps.bcaresearch.com. 23 It will also be important to see if leading politicians continue to defect from other parties and flock to her ranks. Especially politicians from the LDP, and especially those who are not worried, like Mineyuki Fukuda, about losing their seats anyway. 24 It also neglects recent reforms to the electoral system that will eliminate ten seats, only one of which is likely to go to the Party of Hope. 25 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 26 Please see Bank of Japan, "Summary Of Opinions At The Monetary Policy Meeting," September 20-21, 2017, p. 5, available at www.boj.or.jp/en.
Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Overweight Machinery stocks have been in a V-shaped recovery for the past 18 months retracing all of their relative losses since the 2014 highs. Our machinery EPS model is firing on all cylinders (second panel), underscoring that the earnings-led recovery has more running room, giving us comfort to act on our upgrade alert and lift the S&P construction machinery & heavy truck subindex to overweight. We think a fresh capex upcycle will fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (third panel), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. A quick channel check also waves the green flag as industrial production remains expansionary and new orders are outpacing inventory accumulation (bottom panel). Bottom Line: We are acting on our upgrade alert and lifting the S&P construction machinery & heavy truck index to overweight. As a result of this change, we have boosted the S&P industrials sector to an above benchmark allocation. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.
Highlights Chart 1Tax Reform Is A Bear-Steepener The federal government provided some details about its tax reform proposal last week. Markets reacted immediately, once again starting to price-in the possibility of lower tax rates. A basket of high tax-rate stocks outperformed the S&P 500, although the relative price remains well below the highs reached in the immediate aftermath of the election (Chart 1). Bond markets have also been influenced by the "will they, won't they" tax reform drama. Since tax cuts at this relatively late stage of the economic cycle are widely expected to be inflationary, the slope of the yield curve steepens and long-dated TIPS breakevens widen whenever the passage of a tax bill seems more likely. Our political strategists expect that a tax bill will be passed by the end of Q1 2008, or by early Q2 at the latest.1 All else equal, this will bias TIPS breakevens wider and cause the Treasury curve to steepen. Even in the absence of significant tax legislation we think that TIPS breakevens will widen and the yield curve will steepen as inflation starts to pick up during the next few months. But any fiscal stimulus related to tax reform would certainly expedite the process. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 87 basis points in September, bringing year-to-date excess returns up to 234 bps. The average index option-adjusted spread tightened 9 bps on the month to reach 101 bps. Valuation looks increasingly stretched across much of the corporate bond universe. The 12-month breakeven spread for A-rated corporate bonds has dipped well below its mid-2014 trough and is approaching the minimum value witnessed in the early stages of prior Fed tightening cycles. The same measure for Baa-rated credits fell to 17 bps last month, almost exactly equal to its mid-2014 low. While spreads are somewhat expensive, recent data on profit and debt growth have been positive. We noted in last week's report2 that net leverage declined in the second quarter, breaking a streak of two consecutive increases (Chart 2). In addition, other credit cycle indicators such as the slope of the yield curve and C&I bank lending standards do not yet signal wider spreads. Further declines in leverage will depend on whether profit growth can sustain its recent strength (bottom panel). While some moderation is likely, as of now, our leading profit indicators - particularly the weak dollar and surging manufacturing PMI - suggest that growth will stay firm for the remainder of the year (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 143 basis points in September, bringing year-to-date excess returns up to 526 bps. The index option-adjusted spread tightened 31 bps to end the month at 347 bps, 24 bps above the mid-2014 cycle low. After adjusting for expected default losses, we calculate that the junk index currently offers an excess spread of 213 bps. We would expect a default-adjusted spread at this level to translate into low, but positive, excess returns during the next year. A simple linear regression suggests those excess returns will be on the order of 100 to 200 bps (Chart 3), but with a fairly wide margin for error. The default-adjusted spread incorporates our estimate of default losses for the next 12 months. This estimate currently sits at 1.3%. The estimate is derived from the Moody's baseline forecast of a 2.7% default rate and our own estimate of a 51% recovery rate (bottom panel). The relatively benign default outlook is reinforced by the persistent environment of steady growth and low inflation. Last week's third estimate showed that second quarter GDP growth was 3.1%, well above most estimates of trend. Meanwhile, the St. Louis Fed Price Pressures Measure predicts only a 2% chance that inflation will rise above 2.5% during the next year (panel 3). This combo of steady growth and low inflation will ensure that Fed policy remains sufficiently accommodative to support high-yield bond returns. MBS: Upgrade To Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 35 basis points in September, bringing year-to-date excess returns up to 26 bps. The conventional 30-year MBS yield rose 10 bps in September, driven by a 19 bps increase in the rate component. This was partially offset by an 8 bps tightening of the option-adjusted spread (OAS), while the compensation for prepayment risk (option cost) narrowed 1 bp. OAS have widened considerably during the past few months. In all likelihood this has been in anticipation of the Fed starting to unwind its MBS portfolio. The result is that MBS no longer look expensive compared to Aaa-rated credit (Chart 4). With more attractive valuations and the Fed's schedule for balance sheet runoff now well known, we think the time is right to edge MBS exposure higher. After having sold the rumor of Fed balance sheet runoff, it is time to buy the news. Arbitrage between MBS and credit should limit how much MBS OAS can widen during the next 6-12 months, even in the face of higher MBS supply. Further, recent spread widening has been helped along by falling mortgage rates and rising refinancings. With Treasury yields and mortgage rates now poised to put in a bottom, refis will also roll over and lend support to the MBS trade (bottom panel). Government-Related: Underweight Chart 4MBS Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to 181 bps. Sovereign bonds outperformed the Treasury benchmark by 93 bps on the month. Foreign Agencies and Local Authority bonds outperformed by 25 bps and 46 bps, respectively. Domestic Agency bonds outperformed by 1 bp and Supranationals outperformed by 3 bps. Year-to-date Sovereign bond outperformance has been spurred by dollar weakness, even though spread differentials are tilted firmly in favor of domestic U.S. credit (Chart 5). But with U.S. economic data just now starting to surprise to the upside, we think the tailwind from a weakening dollar is about to fade. Mexico is the single largest issuer in the Sovereign index, and appreciation in the peso versus the U.S. dollar has been a particularly important driver of Sovereign outperformance this year. However, our Emerging Markets Strategy team now believes that peso appreciation is overdone.3 Mexican growth has been supported by strong exports and a weak currency while domestic demand has been soft. Without a solid foundation from domestic demand, this year's currency appreciation will soon cause inflation to roll over and Mexican interest rates to fall. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 62 basis points in September (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 207 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged up from 84% to 86% in September, but it remains extremely tight relative to its post-crisis trading range (Chart 6). State & local government budgets dodged a bullet when the Graham-Cassidy healthcare reform bill was defeated last month. The bill included a block-grant provision for Medicaid that would have reduced federal government transfer payments, a significant source of state & local government revenue. Last week we also learned more specifics about the federal government's proposed tax reform legislation. While the lower tax rates in the proposal are obviously negative for M/T yield ratios, the impact should be somewhat offset by the elimination of tax deductions, the state & local income tax deduction in particular. Eliminating deductions makes the tax advantage in municipal bonds appear more attractive, irrespective of the tax rate. Most importantly, the municipal bond tax exemption itself appears safe. Of course, it will still be some time before we know the final details of tax reform, which our political strategists expect will be passed by the end of Q1 2018. With the plan still not finalized, M/T yield ratios near post-crisis lows look too complacent. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in September and steepened out to the 5-year maturity point. The 2/10 Treasury slope steepened 7 bps and the 5/30 slope flattened 9 bps. The market brought a December rate hike back into focus last month following a somewhat stronger CPI inflation report and Fed Chair Janet Yellen's insistence that low inflation will prove transitory. Our 12-month fed funds discounter, which shows the market's expected change in the fed funds rate during the next 12 months, moved up to 40 bps from 19 bps. As discussed in last week's report,4 we tend to agree with Chair Yellen that inflation will soon follow growth indicators higher. The market implication of this thesis is that wider TIPS breakevens will lead to one last bout of curve steepening this cycle. We continue to position for curve steepening via a trade long the 5-year bullet and short a duration-matched 2/10 barbell. This trade has returned 16 bps since inception last December. At present, our fair value model shows that the 5-year bullet is slightly expensive on the curve (Chart 7). Or put differently, that the 2/5/10 butterfly spread is fairly priced for 2 bps of 2/10 curve steepening during the next 6 months.5 We think curve steepening will easily surpass this threshold and maintain our long 5-year, short 2/10 position. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in September, bringing year-to-date excess returns up to -131 bps. The 10-year TIPS breakeven inflation rate rose 8 bps on the month but, at 1.84%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. CPI beat expectations in August for the first time in several months and, as was discussed in a recent report,6 the bond market was quick to react to even a tentative sign that inflation might have troughed. The market's sensitivity should not be surprising. Leading pipeline indicators of inflation, such as the prices paid and supplier deliveries components of the ISM manufacturing index, suggest that inflation and TIPS breakevens are biased higher (Chart 8). Counter-acting some of the optimism on inflation was the slightly weaker-than-expected August PCE report. While trimmed mean PCE inflation did perk up on a month-over-month basis, the 6-month and 12-month rates of change continue to fall (bottom panel). The 2% inflation target is of utmost importance to the Fed. In our base case scenario there is sufficient inflationary pressure for this target to be achieved with a pace of rate hikes similar to the Fed's median projection. But if that turns out not to be the case, then the Fed will respond with a slower pace of hikes. Either way, long-maturity TIPS breakevens must move higher before the end of the cycle or the Fed will have failed. ABS: Cut To Neutral Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in September, dragging year-to-date excess returns down to 68 bps. Credit card and auto loan ABS both underperformed the duration-equivalent Treasury benchmark by 2 bps in September, pulling year-to-date excess returns down to 67 bps and 69 bps, respectively. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month to reach 39 bps. It remains well below its average pre-crisis level (Chart 9). At 39 bps, the Aaa-rated ABS spread is still 11 bps wider than the average option-adjusted spread for conventional 30-year agency MBS. However, as we observed in last week's report,7 delinquency rates for consumer credit (credit cards, auto loans and student loans) are rising, while mortgage delinquency rates continue to fall. This squares with the message from the Fed's Senior Loan Officer Survey which shows that lending standards are tightening for both credit cards and auto loans (bottom panel). While delinquencies appear to have bottomed, the charge-off rate in credit card ABS collateral pools remains near all-time lows. Meanwhile, net losses in auto loan ABS collateral pools are in a clear uptrend. We continue to prefer Aaa-rated credit card ABS over Aaa-rated auto loan ABS, but are wary that credit card charge-offs will also start to increase in the near future, albeit from very low levels. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in September, dragging year-to-date excess returns down to 110 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, but it remains well below its average pre-crisis level. Fundamentally, the commercial real estate space continues to be characterized by tightening lending standards and falling demand (Chart 10) and, outside of the multi-family sector, CMBS delinquencies are trending higher (panel 5). Against this back-drop, spreads are not wide enough to entice us. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to 62 bps. The average index option-adjusted spread for the Agency CMBS index widened 3 bps on the month to reach 51 bps. This compares favorably to the 39 bps offered by Aaa-rated consumer ABS and the 28 bps offered by conventional 30-year Agency MBS. Especially since multi-family delinquency rates remain very low. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.65% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.62%. The Global Manufacturing PMI held flat at 53.2 in September, while bullish sentiment toward the dollar crept higher. This caused our model's fair value to edge lower to 2.65% from 2.67%. The U.S., Eurozone and Japan all saw stronger PMIs in September. While China's PMI dipped slightly (from 51.6 to 51), it remains firmly above the 50 boom/bust line. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?", dated September 20, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, avail-able at usbs.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017, available at ems.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For further details on our fair value model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 29th, 2017. The model sharply reduced its allocation to the U.K. to a bare minimum in response to the tightening in liquidity condition as the Bank of England warned of a rate hike in "coming months." The funds are reallocated to the Spain and Germany. Other smaller changes are the reductions in Italy and Australia in favor of Sweden and Switzerland, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 44 bps in September. Both level 1 and level 2 models performed well, with level 2 outperforming its benchmark by 63 bps and level 1 outperforming its benchmark by 9 bps, as the underweight in Australia, U.S. and Japan versus the overweight in Italy, Germany and Netherland worked very well. Since going live in January 2016, the overall model has outperformed the benchmark by 341 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 743 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 September 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to be optimistic on global growth as seen by an increasing allocation to cyclical sectors. Additionally, the model has also reduced its underweight on consumer discretionary stocks, which is currently the only cyclical sector to have a below-benchmark allocation. Finally, the biggest shift was a downgrade in utilities from overweight to underweight. This was primarily driven by momentum. 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
Highlights Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.