Developed Countries
Highlights Chart 1Too Close For Comfort The Fed is in the midst of tightening policy, but with inflation still below target it wants to ensure that overall policy settings remain accommodative. In the language of central bankers, the Fed wants to keep the real fed funds rate below its equilibrium level, the level that applies neither upward nor downward pressure to price growth. The equilibrium fed funds rate cannot be calculated with precision, but one popular estimate shows that policy settings are dangerously close to turning restrictive (Chart 1). While an announcement of balance sheet reduction is almost certain to occur next month, with the real fed funds rate so close to neutral, rate hikes are probably on hold until the gap widens. Higher inflation will widen the gap by causing the real fed funds rate to fall, and we are confident that core inflation will rise in the coming months (see page 11 for further details). This will permit the Fed to deliver more than the currently discounted 28 bps of rate increases during the next 12 months. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in July, bringing year-to-date excess returns up to 209 bps. The financial press is littered with stories highlighting extremely unattractive corporate bond valuations, but we think this storyline is exaggerated. In fact, the average spread on the Bloomberg Barclays corporate bond index is somewhat wider than is typically observed in the early stages of a Fed tightening cycle (Chart 2). We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 86 bps and traded in a range between 66 bps and 104 bps.1 Viewed in this context, the current spread of 102 bps looks somewhat cheap. That being said, corporate balance sheet health is worse than is typically seen during the early stages of a tightening cycle and this will limit spread compression from current levels. But all in all, excess returns to corporate bonds should be consistent with carry during the next 6-12 months, with higher inflation and tighter Fed policy being pre-conditions for material spread widening. In a recent report2 we showed that bank bonds (both senior and subordinate) still offer a spread advantage compared to other similarly risky sectors (Table 3). Banks also continue to make progress shoring up their balance sheets and the outlook for bank profits is starting to brighten. 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 83 basis points in July, bringing year-to-date excess returns up to 448 bps. The index option-adjusted spread tightened 12 bps to end the month at 352 bps, 8 bps above the 2017 low. We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread almost in line with the average witnessed during other similar monetary environments. In contrast, the VIX index, which co-moves with junk spreads (Chart 3), is well below levels seen during the early stages of the prior two tightening cycles. The VIX currently sits at 10, and its historical range in similar monetary environments is between 11 and 17, with an average of 13.3 In this way, there would appear to be more room for investment grade corporate bond spreads to tighten than junk spreads, especially on a volatility-adjusted basis. Despite somewhat more stretched valuations than in investment grade, high-yield still offers reasonable compensation relative to expected defaults. At present, our estimated default-adjusted spread is 206 bps, only slightly below its historical average (panel 3). This is based on an expected default rate of 2.8% during the next 12 months and an expected recovery rate of 48% (bottom panel). MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to 4 bps. The conventional 30-year MBS yield declined 3 bps in July, as a small 1 bp increase in the rate component was offset by a 4 bps tightening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. Index OAS has been in a widening trend since bottoming at 15 bps last September (Chart 4). Since then, MBS have returned 43 bps less than duration-equivalent Treasury securities. The Bloomberg Barclays Aaa-rated Credit index has outperformed Treasuries by 71 bps during that same timeframe. The back-up in OAS reflects, in large part, the market pricing in the upcoming wind-down of the Fed's balance sheet, set to be announced next month. However, we think OAS still have further to widen to catch up with the rising trend in net issuance. According to Flow of Funds data, net MBS issuance totaled $83 billion in the first quarter. If that pace continues for the rest of the year, then 2017 will be the strongest year for MBS issuance since 2009. While higher mortgage rates since the end of 2016 present a drag, at least so far, home sales have not shown much weakness (bottom panel). This is unlike the 2013 taper tantrum when home sales fell sharply following the surge in rates. We are underweight MBS on the expectation that the housing market will remain resilient in the face of higher rates, allowing issuance to continue its uptrend. However, we are closely tracking the spread advantage in MBS compared to Aaa-rated credit which is finally starting to look attractive (panel 3). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to 149 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 81 bps and 112 bps, respectively. The low-beta Supranational and Domestic Agency sectors each outperformed by 5 bps. The Foreign Agency sector outperformed the duration-matched Treasury index by 56 bps. USD-denominated sovereign bonds have underperformed the Baa-rated U.S. Corporate index (their closest comparable in terms of risk) during the past three months even though the U.S. dollar has continued its trend lower (Chart 5). But despite this recent underperformance, the Sovereign index still does not offer a spread advantage over the Baa-rated U.S. Corporate index (panel 3). Further, while our Emerging Markets Strategy service still looks favorably upon the Mexican peso relative to other emerging market currencies, it does not expect the peso to continue its recent appreciation versus the U.S. dollar.4 We share this opinion, and expect the broad trade-weighted dollar to appreciate as U.S. growth rebounds in the back-half of the year.5 In our cross-sectional model, which adjusts spreads for credit rating and duration. Local Authorities and Foreign Agencies continue to look attractive compared to most U.S. corporate sectors. In contrast, the Sovereign and Supranational sectors appear expensive. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 38 basis points in July (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 186 bps year-to-date. The average Municipal / Treasury (M/T) yield ratio fell 2% in July, breaking below 85%. The average yield ratio remains extremely tight relative to its post-crisis trading range (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. Our early estimate, based on the recently released second quarter National Accounts data, shows that state & local government net borrowing probably moved higher in Q2 (panel 3), making the recent decline in yield ratios appear even more tenuous. The increase in net borrowing stems largely from a $21 billion drop in income tax revenues and a $20 billion decline in transfer receipts from the federal government. Income tax revenue should recover in the next two quarters,6 and we expect net borrowing will also start to decline. However, it is unlikely that net borrowing will fall by enough to justify current muni valuations. On July 6, the state House of Illinois overrode Governor Bruce Rauner's veto to finally pass a $36 billion budget. The move was sufficient for Moody's and S&P to both subsequently affirm the state's investment grade rating. The 10-year Illinois General Obligation bond yield declined 102 bps on the month, despite only a 1 bp drop in the 10-year Treasury yield. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull steepened in July. The 2/10 slope steepened 3 bps and the 5/30 slope steepened 10 bps. We currently recommend two tactical trades designed to profit from movements in the Treasury curve. First, we have been recommending a short position in the July 2018 fed funds futures contract since July 11.7 From current levels, we calculate this trade will deliver an un-levered return of 28 bps if there are two hikes between now and then, and 53 bps if there are three hikes. Our second recommendation is a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell, a trade designed to profit from a steepening of the 2/10 yield curve. It remains our view that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve. We expect the 2/10 slope to steepen as inflation rebounds during the next few months. Two weeks ago we published a Special Report 8 that explained our rationale for taking views on the slope of the curve using butterfly trades. It also explained our butterfly spread valuation model, and how we use that model to determine how much steepening/flattening is currently discounted in the yield curve. According to our model, the curve is priced for 9 bps of 2/10 steepening during the next six months (Chart 7). Our recommended butterfly trade will earn positive returns if the curve steepens by more than that. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in July. The 10-year TIPS breakeven inflation rate rose 9 bps on the month and, at 1.8%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Core inflation has moved sharply lower since February, but the fact that our Phillips Curve model of core inflation has not rolled over makes us inclined to view the downtrend as transitory. Also, during the past few weeks we have seen some preliminary signs that inflation is on the cusp of rebounding. Year-over-year core PCE inflation ticked higher in June for the first time since January. The PCE diffusion index, which has a good track record capturing near-term swings in core PCE, moved sharply higher (Chart 8). The prices paid components of the ISM manufacturing and non-manufacturing surveys increased from 55 to 62 and from 52.1 to 52.7, respectively, in July. We expect stronger realized inflation will lead TIPS breakevens higher during the next few months. However, even in a scenario where core inflation fails to rebound, the downside in breakevens from current levels is limited. The reason is that if inflation remains very low, the Fed will most likely refrain from hiking rates in December. Such a dovish capitulation from the Fed would put upward pressure on breakevens at the long-end of the curve. We discussed this possible scenario in more detail in a recent report.9 ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in July, bringing year-to-date excess returns up to 59 bps. The index option-adjusted spread for Aaa-rated ABS held flat on the month, and remains well below its average pre-crisis level. The Federal Reserve released its Q2 Senior Loan Officer Survey last week. It showed that credit card lending standards moved back into "net tightening" territory after having eased the previous quarter (Chart 9). Auto loan lending standards tightened on net for the fifth consecutive quarter. Tightening lending standards are usually a response to deteriorating credit quality, and thus tend to correlate with higher losses and wider spreads. In that regard, net loss rates for auto loans continue to trend higher, and Moody's data show that the cumulative loss rate for prime auto loans originated in 2017 is worse than for any vintage since 2009, for loans with the same age. Conversely, the mild tightening in credit card lending standards has so far not translated into rising charge-offs (Chart 9), but the situation bears close monitoring. For now, we are content to remain overweight ABS given the attractive spread pick-up compared to other similarly risky sectors. However, we also recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans, even though auto loans now once again offer an attractive spread differential, after adjusting for differences in duration and spread volatility (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 39 basis points in July, bringing year-to-date excess returns up to 96 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, and remains below its average pre-crisis level. The Fed's Q2 Senior Loan Officer Survey showed that lending standards for all classes of commercial real estate (CRE) loans tightened, on net, for the eighth consecutive quarter. The survey also reported that demand for CRE loans is on the decline (Chart 10). The combination of tighter lending standards and weak loan demand suggests that credit concerns continue to mount in the private CMBS space. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to 65 bps. The average option-adjusted spread for the Agency CMBS index held flat on the month but, at 49 bps, the sector continues to look attractive compared to other similarly risky alternatives.10 Not only does the sector offer attractive spreads, but the agency guarantee and the lower delinquency rate in multi-family loans compared to other CRE loans (panel 5) makes its risk/reward profile particularly appealing. 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 2.62% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.63%. The U.S. PMI bounced back in July, after having trended lower for most of this year. The Chinese PMI also increased last month, while the Eurozone reading moderated somewhat from a very high level (panel 4). Overall, the Global PMI came in at 52.7 in July, up from 52.6 in June. Bullish sentiment toward the U.S. dollar has also fallen sharply in recent weeks (bottom panel). Bearish dollar sentiment in an environment of expanding global growth sends a very bond-bearish signal. It means that the entire world is participating in the global expansion and any increase in Treasury yields is less likely to be met with an influx of foreign buying. 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 2.26%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Range calculated using monthly data, specifically the final day of each month. 2 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 3 Ranges for junk spread and VIX calculated using monthly data, specifically the final day of each month. 4 Please see Emerging Markets Strategy Weekly Report, "The Case For A Major Top In EM", dated July 12, 2017, available at ems.bcaresearch.com 5 Mexico carries the largest weight in the Sovereign index, accounting for 23% of market cap. 6 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 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)
Highlights July jobs report friendly for risk assets. Q2 earnings and July ISM confirm bullish profit environment. The Fed acknowledges softer inflation, but remains determined to tighten policy. 1H economic growth is just enough for the Fed. Housing weakness in Q2 is not a concern. Feature Chart 1Labor Market Conditions Favor Risk Assets The July jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 209,000 jobs in July, well above the consensus forecast of 178,000. Prior months were also revised higher by 2,000 pushing the 3-month moving average up to 195,000 jobs per month. Monthly job gains thus far in 2017 are nearly identical to the 187,000 jobs per month averaged in 2016. Despite an uptick in the participation rate to 62.9% from 62.8%, the unemployment rate dipped by 0.1% to 4.3%. At two decimal points, the dip in the jobless rate was from 4.36% to 4.35%. Although the monthly increase ticked up to 0.3%, the annual increase in average hourly earnings was flat at 2.5% for the fourth consecutive month (Chart 1). Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.8% in July supports the Fed's view on inflation. Bottom Line: The July employment report paints a fairly stable picture of the U.S. economy. Job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. Meanwhile, wage gains remain modest and consistent with muted inflation. We still expect the Fed to announce the process of running down its balance sheet at the September FOMC meeting. The next rate hike will likely come at the December FOMC meeting, if inflation rebounds in the second half of the year. Steady growth, low inflation and a gentle Fed should continue to underpin U.S. risk assets. Q2 Earnings Update: Margin Expansion In Place EPS and sales growth in Q2 are running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. More than 80% of companies have reported results so far with 73% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 2). Furthermore, 68% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, over the nearer term, results thus far imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 12% with revenue growth at just 5%. The BCA Earnings model predicts EPS growth to hit roughly 24% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 3). Measured on this basis, S&P 500 EPS growth in Q2 would be 20%, compared with 13% in Q1. Chart 2Positive Earnings Surprises Continue Chart 3Strong EPS Growth Ahead Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share are higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results are particularly strong in energy, technology and financials. Energy revenues surged by 15.7% in Q2 versus a year ago. Sales gains in technology (8.2%), materials (7.2%) and utilities (5.7%) are notable. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (Chart 4) has been encouraging. The forecast for 2017 is 12%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. The 2018 estimate (11%) is also little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Table 1S&P 500:##BR##Q2 2017 Results* Chart 4Stability In '17 & '18 EPS##BR##Estimates Supports U.S. Equities BCA's U.S. Equity Strategy service noted1 that the lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are absent from Q2 conference calls; the domestic market appears front of mind for both investors and management teams. We are inclined to see fading concerns about the dollar from the next Beige Book (due in early September) as evidence in favor of our colleagues' view. The July reading of the ISM manufacturing Index supports our case for accelerating profits in the second half of 2017. From the perspective of risks to our stance, industrial production (IP) has historically been a good proxy for sales of S&P 500 companies (Chart 5); and a rollover in the 12-month change in IP would challenge our constructive view towards earnings. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 5, panel 1). Chart 5Favorable Macro Backdrop For Earnings And Sales At 56.3 in July, the ISM has rebounded from its recent low of 47.9 in 2015, but ticked down from the 57.8 reading in June. For many investors, the risk is that the index has peaked and will soon roll over. While a decline is certainly possible given that the index is already elevated, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 6). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 7). Chart 6IP Poised To Accelerate##BR##And Support EPS Growth Chart 7U.S. IP Growth Still##BR##Other Developed Markets Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather momentum in the second half of 2017. Firm readings on ISM indicate that our bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. Fed Still On Track The July FOMC statement supports our view that the Fed will announce plans to shrink its balance sheet at the September FOMC meeting and hold off until December for the next rate hike. Policymakers upgraded their views of the labor market and downgraded their assessments of inflation. The reference to job gains moderating was dropped; instead, the Fed noted that employment growth has been robust. On inflation, the Fed stated that it is "running below" 2%, as opposed to "somewhat below" 2% in the June statement. These are only small tweaks and do not suggest any deviation from the Fed's plan to raise rates one more time this year as per its latest "dot plot" published in June. We still see the next rate hike in December if inflation begins to turn higher and shows signs of heading towards the 2% target. While the Fed is on the sidelines regarding rate hikes until the final meeting of 2017, it is creeping closer to begin shrinking its balance sheet. The July FOMC statement announced that the balance sheet normalization process will begin "relatively soon." The Fed had previously stated that the process would commence "this year." We view this shift in language as a signal that the balance sheet announcement will be made at the September meeting. Hesitation on tapering by the ECB, persistently weak readings on U.S. inflation or a tightening of U.S. financial conditions, would also give the Fed reason to reassess its plan. Bottom Line: Slight variations in the FOMC's statement indicate that rates are on hold at least until December. This will give the Fed time to determine whether inflation is moving back to its target and to assess the market impact of shrinking its balance sheet. 1H GDP: Just Enough U.S. GDP grew by 2.6% in Q2, following a revised 1.2% advance in Q1 (Chart 8). Given the potential distortions to the quarterly data from residual seasonality issues, an average of the first two quarters gives a better reading on the underlying trend in the economy. In the first half of this year, growth averaged 1.9%. On a year-over-year basis, the economy grew by 2.1%, and while that is only in line with the Fed's 2.1% forecast for 2017, it is above the central bank's view of 1.8% GDP growth in the "longer run." In addition, the NY Fed's Nowcast for Q3 is 2.0% and the Atlanta Fed's GDP now reading for Q3 is 3.7%. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time.2 Quarterly GDP has averaged 2.2% since the current expansion started in the second half of 2009. Chart 8GDP Growth Remains Below Average, But Above Fed's Long Run Target Looking beyond the quarterly fluctuations, the U.S. economy has been relatively stable at about 2% growth for nearly 10 years. This advance has been sufficient to lower unemployment, with trend GDP growth slowing due to weak productivity gains and demographics. However, the expansion has not yet led to a material acceleration in wage growth or inflation. Inflation, a lagging indicator, warrants more attention from investors. BCA's Global Investment Strategy,3 team recently argued that both cyclical and structural forces will boost inflation in the next year and far into the next decade. In making this assessment, it was noted that inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended. The implication is that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. This also suggests that the central bank already may be behind the curve on raising rates. The implication for investors is to stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Bottom Line: Despite historically weak readings on economic growth, the U.S. economy is advancing quickly enough to reduce slack and ultimately, push up inflation. We agree with the Fed that gradual increases will forestall more aggressive hikes later in the cycle. Strong Housing Sector Dips In Q2 We expect housing to continue to add to GDP growth in 2017 and beyond. Housing - as measured by residential fixed investment - subtracted 0.27% from GDP growth in Q2 2017. However, since early 2011, the sector has contributed to growth in 20 of 25 quarters. Moreover, the Q2 decline appears to be a one off, with all of the weakness coming in "other structures," which measures broker commissions, manufactured housing and home improvement. The more economically sensitive single-family sector added 0.31% to GDP in Q2. There are few signs of the severe imbalances in housing and housing-related debt that sparked the 2007-2009 global financial crisis. Chart 9 shows that housing investment is running behind other long "slow burn" recoveries.4 These recoveries lasted well beyond the point at which the economy hit full employment, and inflationary pressures were also slower to emerge. The housing sector's lag is not surprising given the bloated inventory of vacant, unsold and foreclosed homes that needed to be absorbed in the early part of this recovery. Chart 10 shows the overhang has disappeared. Moreover, recent anecdotal reports suggest that the limited supply of homes in areas where people want to live is hurting sales. Chart 9We Are In A "Slow Burn" Expansion Chart 10Solid Housing Fundamentals In Place Other positive factors for housing include: A rise in FICO scores, which indicates that more renters now qualify for loans and could move from a rental unit to a single family house. We highlighted this factor in a recent Special Report on housing.5 Housing affordability: although off its all-time high, it remains favorable and the cost of owning remains cheap relative to renting. The rate of home ownership is now well below its long-term average (Chart 10, panel 2). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit compared with single-family homes. The supply of foreclosed homes on the market is almost nil. While this may not directly impact home construction and GDP directly, it supports higher home prices. Lending standards have not eased much in this cycle, and accordingly, have not been a net plus for the housing market. Nonetheless, more selective mortgage lending by banks in this cycle stands in sharp contrast to the lax lending in the last cycle, with the net result being better credit quality for bank mortgage portfolios and less systemic risk in the banking sector. This is an area the Fed is paying close attention to in this cycle.6 That said, with lending standards tight, there is room for them to loosen and provide an additional boost to housing in the future. Household formation is still recovering from a period in which young adults stayed home with their parents for longer than normal for economic reasons. Although mild by historical standards, the tightening labor market and cyclical rebound in disposable incomes have allowed millennials to move out of their parents' basements, which has boosted housing demand (Chart 11). Chart 12 estimates the remaining pent up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. The equilibrium number of housing starts needed to cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' occurs during the next two years, adding another 250,000 units per year, then total demand could be 1.6 to 1.7 million in each of the next two years. This compares with the July housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.25 percentage points and 0.52 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 13). Chart 11Household Formation##BR##Following Incomes Higher Chart 12A Catch Up In Housing Construction##BR##Will Occur If This Gap Narrows Chart 13Housing Catch Up##BR##Will Boost GDP Growth The implication for the economy is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by an adverse shock and inflationary pressures remain muted, which would allow the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation and a "catch up" phase could stoke the current "slow burn" expansion in the coming years. Residential investment will continue to add to GDP growth in 2017 and beyond, and keep economic growth on track to hit the Fed's modest target. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see U.S. Equity Strategy Weekly Report "Growth Trumps Liquidity", dated July 31, 2017, available at uses.bcarearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017, available at usis.bcarearch.com. 3 Please see Global Investment Strategy Weekly Report "A Secular Bottom In Inflation", dated July 28, 2017, available at gis.bcarearch.com. 4 Please see The Bank Credit Analyst Monthly Report, dated November 24, 2016, available at bca.bcarearch.com. 5 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcarearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017, available at usis.bcaresearch.com.
Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Chart I-14Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
This week's GDP report contained good news for domestic manufacturers; nonresidential fixed investment expanded at a 5.2% annualized rate in Q2, slower than the 7.2% expansion of Q1 but still well above the overall economy at 2.6%. The implication is that confidence in the U.S. economy is high enough that firms are increasingly deploying productive capital into their businesses. Loan growth cycles are typically synchronous with improved business sentiment which, in turn, coincides with firms feeling confident enough to expand the balance sheet. Accordingly, growth in capex and growth in bank loans move in lockstep (second, third and fourth panels). Pre-GFC, the financials index and capex/loan growth moved broadly together. The relationship has broken down, however, in the post-GFC world. We expect above-normal earnings growth in financials to eventually drive a renormalization of valuation multiples and the gap to close. We reiterate our overweight financials recommendation.
Highlights The neutral real rate of interest, R*, is low in most economies, and will only rise gradually over the coming years. Currency movements tend to dampen differences in neutral rates across countries. The fact that R* is higher in the U.S. will limit further downside risk for the dollar. While a variety of structural forces will cap the increase in the neutral real rate, the neutral nominal rate could rise more briskly as inflation picks up. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. We are closing our long GBP/JPY trade for a gain of 9.9% and opening a new trade going short EUR/GBP. EUR/USD will trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of next year. Feature Where Is Neutral? As the global economy continues to recover, central banks are increasingly turning to the question of how to best normalize monetary policy. A key issue in this debate concerns the level of the neutral real rate of interest, commonly referred to as R*. If central banks raise rates too far above the neutral rate, growth could stall. If they don't raise rates enough, inflation could accelerate. The concept of the neutral rate is somewhat difficult to grasp, and we apologize in advance that this report is more abstract than what we are normally accustomed to writing. However, we think that readers who stick with the logic of the piece will be well rewarded with the practical implications that it provides. A Conceptual Framework In thinking about the neutral rate, it is worthwhile to recall the familiar macro identity which states that the difference between what a country saves and what it invests is equal to its current account balance.1 Since one country's current account surplus is another's deficit, globally, the current account balance must equal zero. This, in turn, implies that globally, savings must equal investment. What happens when desired global savings exceed desired investment? The answer is that interest rates will fall.2 Lower rates will incentivize firms to undertake more investment projects, while discouraging household savings. Investment will rise and savings will decline by just enough to ensure that the global savings-investment identity is satisfied. The discussion above aptly captures what happened to the global economy after the financial crisis. The desire of households to boost savings and firms to cut capital spending led to a sharp and sustained drop in the neutral rate. Those who understood this point back in 2010, when the 10-year Treasury yield briefly hit 4%, made a lot of money by being long bonds when most others were fretting about the inflationary effects of QE and large government budget deficits. The Exchange Rate As A Mitigating Force The ability of countries to export their excess savings abroad by running current account surpluses implies that the neutral rate has a large global component. To appreciate this point, consider a simple thought experiment. Suppose the global trading system completely breaks down and every country ends up with a trade balance of zero. For the sake of argument, let us ignore the immense economic dislocations that this would cause and focus simply on the arithmetic impact that this would have on aggregate demand. The U.S. trade deficit currently stands at $567 billion (3% of GDP). Getting rid of it would add about six million jobs. This would likely cause the economy to overheat, forcing the Fed to raise rates. In contrast, the German economy would fall into a deep recession if its €224 billion (7.1% of GDP) trade surplus vanished. The ECB would not be able to raise rates for years. Thus, in the absence of trade, the neutral rate would be higher in the U.S. and lower in the euro area. This simple thought experiment illustrates why the neutral rate partly depends on the value of a country's currency.3 If a country's currency strengthens, all things equal, its neutral rate will fall. The extent to which the currency appreciates will depend on how long the forces causing neutral rates to diverge across countries are expected to persist. In general, if the forces are more structural than cyclical in nature, currencies will adjust to a greater degree (Chart 1).4 Chart 1The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot The discussion above helps make sense of currency movements over the past three years. A key reason the dollar began to strengthen against the euro in the second half of 2014 is that investors became convinced that the neutral rate in the U.S. would exceed that of the euro area for a very long period of time. The rally in the euro this year largely reflects a reappraisal of that view. Stronger euro area growth has convinced many investors that the neutral rate in the region may not be as low as previously imagined. The Outlook For The Neutral Rate The savings-investment balance provides a useful framework for thinking about how the neutral rate will evolve over the coming years. With this framework in mind, let us consider the various forces affecting the neutral rate and how they might change over time. The Debt Supercycle Today, almost 60% of Americans want to save more money according to a recent Gallop poll; before the financial crisis, that number was less than 50% (Chart 2). A slower pace of debt accumulation implies less spending and more desired savings. It is possible that households will become more willing to take on debt as the memories of the Great Recession fade. However, a return to the reckless lending standards of the pre-crisis period is unlikely. Thus, while the end of the deleveraging cycle in the U.S. will push up R*, it will remain low by historic standards. Globally, efforts to reduce leverage have been more halting. In fact, in many emerging markets, debt levels are higher today than in 2008 (Chart 3). This will weigh on R*. Chart 2Return To Thrift Chart 3EM Debt At All-Time Highs The "Amazonification" Of The Economy Chart 4Savings Heavily Skewed Towards Top Earners Technological progress is nothing new, but unlike past inventions which typically replaced man with machine, many of today's innovations appear to be reducing the need for both labor and physical capital.5 Companies like Amazon are laying waste to America's retail sector. Uber and Airbnb are providing ways to use the existing stock of capital more efficiently. Fewer shopping malls, taxis, and hotels means less investment, and less investment means a lower neutral rate. Inequality One of the distinguishing features of the "Amazon economy" is that it is dominated by a few winner-take-all firms. This has generated huge payoffs for their owners, but paltry returns for everyone else. While this is not the only trend fueling income inequality, it has certainly exacerbated it. Rising inequality redistributes income from households that tend to live paycheck-to-paycheck to those who save a lot (Chart 4). This increases aggregate desired savings, leading to a lower neutral rate. However, rising inequality may also generate a political backlash. Donald Trump's ability to take over the Republican party was partly driven by the disillusionment of Republican voters over the GOP's pro-business positions on issues such as immigration and trade. Historically, populism has been associated with larger budget deficits. To the extent that budget deficits soak up savings, they lead to a higher neutral rate. Rising populism could also lead to stronger calls for anti-trust policies. Our sense is that we are slowly moving in this direction. Slower Population Growth Demographic shifts can be tricky to assess because they affect savings and investment in offsetting ways and over different time horizons (Chart 5). A decrease in the growth rate of the population will reduce the incentive to expand capacity. Less investment means a lower neutral rate. Slower population growth may also lead to higher savings for a while, as a larger fraction of the population enters its peak saving years (ages 30-to-50). This also means a lower neutral rate. Eventually, however, aging will push more of the population into retirement, increasing the number of people who are dissaving rather than saving. Rising government spending on health care and pensions could also lead to larger fiscal deficits, further depleting national savings. We may be approaching this outcome. Chart 6 shows that the global "support ratio" - defined as the number of workers relative to the number of consumers - has peaked globally and will start falling sharply over the coming years. Chart 5An Aging Population Eventually Pushes Up Interest Rates Chart 6The Ratio Of Workers To Consumers Have Peaked Slower Productivity Growth As with population growth, slower productivity growth is likely to depress R* at first, but could raise R* over time (Chart 7). Initially, slower productivity growth will prompt firms to curb investment spending. It could also lead to less consumer spending, as households react to the prospect of smaller gains in real incomes. All this implies a lower neutral rate. Eventually, however, chronically weak income growth is likely to deplete national savings, leading to a higher neutral rate. The U.S. and a number of other economies may be getting increasingly close to that inflection point (Chart 8). Chart 7A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Chart 8Weak Supply Growth Has Narrowed Output Gaps Lower Commodity Prices Swings in commodity prices may also generate offsetting pressures on the neutral rate that manifest themselves over different time horizons. At the outset, lower commodity prices tend to depress investment spending in the resource sector. This implies a lower neutral rate. Over time, however, lower commodity prices may generate new investment opportunities in downstream industries that use fuel as an input. Lower commodity prices also put money into the pockets of poorer households who are likely to spend it. This raises the neutral rate. Investment Implications Given the conflicting forces affecting R*, it is difficult to have much certainty over how it will evolve. Our best guess is that R* will increase over the next few years, as the scars from the financial crisis recede, deleveraging headwinds abate, fiscal deficits in some economies widen, and population aging and lower productivity growth make more of a dent in national savings. However, the rise in R* is likely to be gradual and from what is currently a very low base. Where we do have greater conviction is on two points: First, the neutral nominal rate will rise more quickly than the neutral real rate, as inflation picks up in most economies. As discussed last week, central banks have a strong incentive to try to engineer more inflation in situations where the economy needs a low real rate to maintain full employment.6 Getting inflation up has been a struggle ever since the financial crisis began, but now that spare capacity around the world is dissipating, central banks are likely to gain more traction over monetary policy. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. Second, the forces pushing down R* outside the U.S. will remain more pronounced than those in the U.S. This, in turn, will provide some support to the beleaguered U.S. dollar. Investors, in particular, may be getting too optimistic about the ability of the ECB to engineer a full-fledged tightening cycle. The euro area is further behind the U.S. in the deleveraging process, suggesting that desired private-sector savings will remain higher there. The overall stance of fiscal policy is also much tighter in the euro area. The IMF estimates that the euro area's structural primary budget surplus currently stands at 0.7% of GDP, compared to a deficit of 1.9% in the U.S. Thus, fiscal policy is currently adding 2.6% of GDP more to aggregate demand in the U.S. than in the euro area. The Fund expects this relative contribution to increase to nearly 4% of GDP by the end of the decade (Chart 9). Furthermore, investment spending has more scope to fall in the euro area. According to the OECD, gross fixed capital formation is actually higher in the euro area than in the U.S. as a share of GDP, despite the fact that potential GDP growth is slower in the euro area (Chart 10). Chart 9Fiscal Policy Is More Stimulative In The U.S. Chart 10Euro Area Investment Spending: Higher Than In The U.S. The appreciation of the euro has led to a tightening in euro area financial conditions in recent weeks, whereas U.S. financial conditions have continued to ease (Chart 11). This will cause relative growth to shift back in favor of the U.S. later this year. Chart 11Diverging Financial Conditions##br## Favor U.S. Over The Euro Area Chart 12The Neutral Rate Is Lowest In The Euro Area The 30-year U.S. Treasury yield is currently 95 basis points higher than the 30-year GDP-weighted euro area government bond yield. This gap in yields does not strike us as being especially large considering that both the neutral rate and long-term inflation expectations are lower in the euro area. We expect EUR/USD to trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of 2018, by which time the Fed will be forced to pick up the pace of rate hikes. The resurgent euro has approached all-time highs against the pound, abetted by a somewhat more dovish-than-expected BoE meeting this week. Yet, with U.K. inflation above target and the unemployment rate at the lowest level since 1975, the Bank of England may need to deliver more than the mere 36 basis points in rate hikes the market is expecting over the next two years. Holston, Laubach and Williams estimate that R* is 1.6 percentage points higher in the U.K. than in the euro area (Chart 12). As such, the balance of risks now favor a stronger pound over a cyclical horizon of 12 months. With that in mind, we are closing our long GBP/JPY trade for a gain of 9.9% and opening a new short EUR/GBP position (Note: The returns of all closed trades are displayed at the back of this report). Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 The difference between what a country saves and what it invests is also equal to the difference between what it earns and what it spends. To see this, note that S=Y-C-G where S is national savings, Y is national income, C is personal consumption, and G is government spending. Hence, the identity S-I=CA can be re-written as Y-(C+G+I)=CA where CA is the current account balance. 2 An obvious question is what happens if desired savings exceed desired investment, but interest rates are already equal to zero. In that case, income will contract. Workers will lose their jobs, making it impossible for them to save. Firms will suffer lower profits or even incur losses in the face of flagging demand. Governments will see tax revenues dry up and spending on welfare programs escalate. This means that household, corporate, and government savings will all decline. Of course, since firms are likely to reduce investment in response to slower growth, this could usher in a vicious cycle where falling demand leads to higher unemployment and even less spending - in other words, a recession or even a depression. 3 Suppose, for example, that the interest rate in Country A were to rise above that of Country B for a period of say, ten years. Country A's currency would appreciate. This would reduce net exports in Country A, leading to a decline in aggregate demand. This, in turn, would prevent the neutral rate in Country A from rising as much as it otherwise would. On the flipside, the cheapening of Country B's currency would push up its neutral rate. 4 In the extreme case where the structural forces are expected to last forever, currencies will adjust to the point where the neutral rate across countries is equalized. Intuitively, this must happen because it is impossible for currency-hedged, risk-adjusted interest rates to be lower in one country than in another for an indefinite amount of time. 5 From a neoclassical economics perspective, one might imagine a "production function" that includes labor, physical capital, and digital capital. Many of today's innovations are raising the return on digital capital relative to those on labor and physical capital. This generates outsized rewards to the owners of this particular form of capital (i.e., internet companies), while potentially undercutting the income of workers and owners of physical capital. 6 Please see Global Investment Strategy Weekly Report, “A Secular Bottom In Inflation,” dated July 28, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Investors are becoming less concerned about China's growth outlook, but there is no sign of euphoria. Monitor three risk factors that could disrupt the positive growth outlook and the bull market in Chinese stocks. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. Remain positive and stay invested. Feature The latest purchasing managers surveys released early this week confirm that the Chinese economy remains buoyant. The manufacturing and service PMIs from both official and private sources remain comfortably in expansionary territory, and there are no signs of a material deterioration from the readings of the sub-indices. Improving growth also appears to be reflected in the stock market. Chinese investable equities have rallied by over 30% so far this year, beating the major global and EM benchmarks (Chart 1). Despite the improvement in the growth numbers and the rally in stock prices, there is no sign of euphoria among investors with respect to China. On the contrary, Chinese stocks' multiples are still among the lowest of the major global bourses (Chart 2). Importantly, ETFs investing in Chinese assets are still witnessing net redemptions: China-focused ETFs listed in the U.S. and Hong Kong have been witnessing constant net capital outflows since 2013 (Chart 3). Even in the first half of this year, these ETFs have continued to lose capital despite rising stock prices - which means retail investors have not participated in the rally. Attractive valuations and lack of "irrational exuberance" suggest the rally in Chinese investable stocks should have further to run. Chart 1Chinese Equities Have Outperformed... Chart 2...But Still With Much Lower Multiples Chart 3... And Net ETF Redemptions Overall, we remain positive on both Chinese equities and the economy's cyclical outlook, and see limited downside risks in the near term, as discussed in detail in recent weeks.1 However, as growth and stock market performance have been largely in line with our expectations, it is always useful to reflect on risk factors. We see three potential risks that could upset the economy and the ongoing rally in Chinese stocks that need to be closely monitored. Will The Trump Wildcard Strike Again? There are increasing signs that tensions between the U.S. and China are on the rise again after a period of relative tranquility. The first round of U.S.-China Comprehensive Economic Dialogue (CED) resulted in no material progress or concrete plans to improve bilateral trade imbalances. U.S. President Donald Trump has continued to pull "China hawks" into his trade policy team, naming Dennis Shea, well known for being highly critical of China's trade practices, as deputy U.S. Trade Representative. Furthermore, the U.S. State Department recently approved a major weapon package to Taiwan, the first arms sales to the Island since 2015. More recently, President Trump has openly accused China of not helping deal with the North Korea nuclear issue after the country tested an intercontinental ballistic missile (ICBM) that it claims can reach continental America. In addition, the Trump administration is reportedly planning trade measures to force Beijing to crack down on intellectual-property theft and ease requirements that American companies share advanced technologies to gain entry to the Chinese market. Overall, it is widely viewed that the brief "honeymoon" in U.S.-China relations following the April Summit between the leaders of the two countries has decisively ended, and the odds for protectionism tactics against Chinese products have increased. The "Trump wildcard" has always been a key risk with respect to our outlook for China2 - the latest developments suggest this risk remains firmly in place. President Trump and his inner circle appear genuinely convinced that punitive tactics could solve the country's chronic trade deficit. Moreover, President Trump has been increasingly bogged down by domestic policy, and he may lash out on the international front in an effort to boost his popularity. Furthermore, the U.S. President has few legal constitutional constraints to using tariffs against trade partners, giving him maneuvering room. From a big-picture perspective, the conflict between the U.S. and China has deep ideological and geopolitical roots, which are even harder to deal with than trade issues. Chart 4Steel Is No Longer Relevant For ##br##U.S.-China Trade Nonetheless, we maintain our guarded optimism that unilateral protectionism measures will not materially undermine Chinese exports, at least in the near term. On the U.S. side, even though President Trump has toughened his rhetoric on China and trade issues of late, it is still far less extreme compared to the promises he made on the campaign trail, in which he pledged to slap a 45% tariff on all imports from China and to label the country a currency manipulator on "day one." So far, the U.S. administration has mainly been focusing on specific industries, particularly steel, rather than broad-based tariffs, the impact of which should be marginal. For example, China accounts for only 3% of American steel imports. Sales to the U.S. account for less than 1% of China's massive steel output (Chart 4). In other words, steel appears to be a highly symbolic sector in Trump's trade policy, but the real impact on China-U.S. trade is negligible. On the Chinese side, the authorities have hard-drawn redlines on political and sovereign issues, but have much greater flexibility on trade-related issues. Chinese officials understand that the country's large surplus with the U.S. puts it at a near-term disadvantage in a trade war, and therefore will likely cave to pressure from the U.S. Moreover, the sectors that President Trump has been complaining about, namely steel and some other base metals, are the same sectors the Chinese government wants to restrict. Therefore, China will not fight for its own "out of favor" industries to disrupt the broader picture in exports. Taken together, President Trump's trade policy has once again become unpredictable, and some punitive measures on specific products appear likely in the near term. However, we still assign low odds of a drastic escalation in trade frictions, and we expect the Chinese authorities to refrain from tit-for-tat retaliation that could lead to a trade war. Protectionism risks, however, will remain a long-term structural issue that complicates the global trade and growth outlook. Deflationary Pressures And The Risk Of Policy Overkill? Chart 5Headline CPI Is Set To Drop Further A key feature of the Chinese economy is strong disinflationary/deflationary pressures, despite robust growth and job creation. Headline inflation to be released next week will likely once again surprise to the downside, mainly due to food prices (Chart 5). Wholesale prices of agricultural products have weakened substantially in recent months, pointing to sharply lower food CPI. Core CPI remains around 1%, underscoring incredibly low inflationary pressures. The key challenge for the Chinese authorities is figuring out how to manage economic policies to achieve the delicate balance between growth and disinflation/deflation. We have long viewed that one of the critical reasons behind China's sharp growth deterioration between 2012 and 2015 was a policy mistake, in which the authorities allowed monetary conditions to tighten dramatically. We are hopeful that the authorities have realized the cost of policy overkill, and will avoid similar mistakes down the road, but the risk certainly cannot be dismissed entirely. For now, we see low odds of policy overkill that could lead to price deflation and negative growth surprises. First, as growth has improved, some policy tightening is warranted. The authorities recently reported that the economy added 7.35 million new jobs in the first half of the year, far exceeding the government's target, pushing the registered urban unemployment rate to 3.95%, the lowest in recent years. In fact, the People's Bank of China may still be behind the curve, meaning that further tightening is simply a "catch-up" and is not immediately restrictive. Chart 6Another Sharp Rally ##br##In The Trade Weighted RMB is Unlikely Second, a major factor behind China's drastic tightening in monetary conditions in previous years was the sharp rally in the trade-weighted RMB, which appreciated by almost 30% between mid-2011 and early/late 2015 - a massive deflationary shock to Chinese exporters (Chart 6). Looking forward, it is extremely unlikely that the PBoC will allow the RMB to rise by a similar magnitude anytime soon. Finally, from investors' perspective, producer output prices are more important to watch for pricing power and profitability. On this front, PPI inflation has also rolled over and will likely continue to downshift, but will not turn to outright deflation in our view. It is important to note that the sharp decline in producer prices in previous years was due to a multi-year deterioration in Chinese growth, which has historically been an anomaly. The only other period in China's post-reform history with falling PPI happened in the late 1990s in the aftermath of the Asian crisis (Chart 7). In other words, falling PPI only occurs under rather extreme growth difficulties. Our model suggests that PPI inflation may decelerate to 3% by year end. Our PPI diffusion index, which measures the percentage of industrial sectors experiencing rising prices, suggests the majority of sectors are still witnessing higher prices both compared with previous months and a year ago (Chart 8). We are monitoring the PPI diffusion index closely to heed a leading signal on corporate pricing power and overall deflationary pressures in the corporate sector. Chart 7Producer Prices: A Historical Perspective Chart 8PPI Watch Bottom Line: A policy mistake of overtightening by the Chinese authorities remains a key threat to the near-term growth outlook, but is not our base case scenario. The Resumption Of The Dollar Bull Market? The U.S. dollar has rapidly dropped out of favor among global investors. The dollar index has fallen by 10% so far this year, the weakest among the major currencies. The weak U.S. dollar has provided a Goldilocks scenario for both the Chinese economy and financial markets: a weaker dollar depreciates the RMB in trade-weighted terms, which is reflationary for the Chinese economy. For investors, the broad dollar weakness also alleviates downward pressure on the CNY/USD, and a stable CNY/USD in turn reduces investors' anxiety on China's macro conditions, pushing up stock prices. This Goldilocks scenario could once again be disrupted if the dollar bull market resumes, and the positive feedback loop goes into reverse. A stronger dollar tends to strengthen the trade-weighted RMB, which is bad news for exporters. Meanwhile, it could rekindle downward pressure on the CNY/USD, re-intensifying domestic capital outflows, which could be viewed as a sign of China's macro troubles. Fears of an economic hard landing would quickly resurface. In our view, Chinese stocks are more vulnerable if the dollar's strength resumes, but the real damage on the broader economy should not be material. It is highly unlikely that Chinese policymakers would allow the trade-weighted RMB to rise alongside the dollar, and will tighten capital account controls to stop domestic capital flight. Chinese equities will suffer in this scenario, as investors' risk aversion increases. However, so long as the Chinese economy and corporate profits do not suffer a major relapse, the rally in stocks should eventually resume. All in all, the three risk factors should be closely monitored in the coming months, especially if investors become increasingly comfortable with the Chinese growth outlook. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. We remain positive on Chinese growth, and favor Chinese equites both in absolute terms and against global/EM benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Overweight The cable & satellite index heavyweights Comcast and Charter Communications both reported their results last week, announcing that they had churned 34,000 and 90,000 of the traditional video customers, respectively. Still, neither company saw a decline in video revenue, reflecting still-strong sector pricing (second panel) and an unabated willingness of the consumer to purchase their content (third panel). The dominant theme from cable & satellite earnings was a transition to high-speed internet (unchanged from the past number of years), a lower revenue but higher margin business. This drove both of the aforementioned companies to each grow their customer relationships by mid-single digits in the quarter. Importantly, the customer additions were made without significantly increasing capital outlays (bottom panel) that, when combined with an overall higher margin business, implies more efficient returns on capital. This should ultimately drive more free cash flow, higher valuation multiples and ongoing share price increases. We reiterate our overweight recommendation for cable & satellite. The ticker symbols for the stocks in the S&P cable & satellite index are: BLBG: S5CBST - CMCSA, CHTR, DISH.
Highlights The euro area's growth prospects, adjusted for population, are no different to any other major developed economy. If the euro area continues its recovery to just the mid-point of its long-term relative growth cycle... ...the yield spread between long-dated bonds in the euro area and the U.S. will compress to around -50 bps from today's -150 bps... ...and euro/dollar will eventually rally to over 1.30. Stay overweight euro area Financials and Retailers versus U.S. Financials and Retailers. Feature ChartThe Euro Area Has Surged Because Expectations ##br##For The Euro Area's 'Terminal' Interest Rate Have Surged Feature The latest GDP releases confirm that the euro area has comfortably outperformed other major developed economies this year. Yet among mainstream equity indexes the Eurostoxx50, which is up 6%, has comfortably underperformed both the MSCI World index1 and the S&P500, which are up 9% and 11%. Why? One clue comes from the technology-heavy NASDAQ 100, which is up 21%. Whereas euro area equities have a negligible exposure to technology, the S&P500 has more than a quarter of its market capitalization in the strongly performing tech and biotech sectors (Chart I-2). Then there is the effect of the surging euro. The largest euro area companies are multinationals earning dollars. In dollar terms, euro area profit growth2 has indeed outperformed U.S. profit growth by about 10%. But converted back into euros - the base currency of the Eurostoxx50 - the outperformance has become an underperformance (Chart I-3). Chart I-2When Technology Outperforms, The Eurostoxx50 Underperforms Chart I-3Euro Area Profits Have Outperformed In Dollars, ##br##But Not In Euros Play Relative Economic Performance Through Bonds And Currencies Chart I-4Euro Area Banks Have Outperformed U.S. Banks The salutary lesson is that sector and currency effects always swamp relative economic performance in predicting or explaining the relative performance of mainstream equity indexes. To play the euro area's economic outperformance, global equity investors must drill down to the more domestically driven euro area sectors, financials and retailers. An overweight position in these two domestic sectors versus their equivalents in, say, the U.S. has outperformed this year, and should continue to do so (Chart I-4). But the best way to play relative economic performance is through other asset classes. Focus not on equities, but on government bonds and currencies. In line with the euro area's superior economic performance this year, the spread between long-dated bond yields in the euro area and U.S. has compressed by 45bps, and euro/dollar is up 12%. The good news is that these trends can ultimately run much further. He That Is Without Structural Problem, Cast The First Stone... Chart I-5For American Men, Labour Force ##br##Participation Rate Is Collapsing The obvious pushback to the longer-term narrative is: what about the euro area's much discussed structural difficulties? To which our response is yes, the euro area does face undoubted long-term challenges. Integrating 19 disparate nations into the confines of an ever closer financial, economic, and ultimately political union is a task that comes with difficulties and risks, especially in the political dimension. Having said that, the euro area is not the only major economy contending with major financial, economic and political challenges in the coming years. To paraphrase the Bible, "he that is without structural problem among you, let him cast the first stone at the euro area." The United Kingdom will spend the next few years struggling to define and redefine the meaning of Brexit, then trying to negotiate it, and then grappling to implement it - whatever 'it' ends up being. The whole process is fraught with financial, economic and political challenges and dangers. Looking West, the United States is suffering a major structural downtrend in its labour participation rate; for American men especially, the participation rate is collapsing (Chart I-5), which creates its own political problems. Looking East, Japan is suffering a chronically low and declining birth rate. And China must wean itself off a decade long addiction to debt-fuelled growth. We could go on... Seen in this light, are the euro area's structural challenges really any harder (or easier) than those faced by the other major economies? The Euro Area Is An Economic Equal One important differentiator across the major developed economies is population growth. A population that is growing boosts headline output. On the other hand, it also adds to the number of people who must share the economy's income and resources. Conversely, a population that is shrinking weighs on headline output, but it reduces the number of people who must share the income and resources. Therefore, what matters for standards of living - and the consequent political implications - is the evolution of GDP per head. In a similar vein, a growing population means that a firm will see rising sales. But absent a rise in productivity, the firm will have to employ more staff and capital to deliver those increased sales - in other words, issue more shares. Therefore, what matters for earnings per share is the evolution of productivity, which once again means GDP per head. Some people consider a shrinking population as a particular problem. They argue that when a population is shrinking, the economy needs to shed workers and capital, which can be hard to do. But a growing population can also create disruptions and pains: specifically, resources such as housing and public services might struggle to keep pace with rapidly rising demand. Consider the United Kingdom. In the 1980s and 90s, the population grew at a very sedate 2% per decade. But since the millennium, population growth has almost quadrupled to 7.5% per decade. The resulting strain on housing and public services was a major factor behind the vote for Brexit - which of course, now carries its own disruptive consequences. Chart I-6The Euro Area Is An Economic Equal Therefore, population shrinkage or growth is a problem only if it is sudden or extreme. More modest changes in either direction are neither good nor bad per se. But to assess progress in living standards and indeed equity market profitability, it is crucial to measure economic growth adjusted for population change. On this population adjusted basis, the structural growth prospects of the euro area are not meaningfully different to other developed economies such as the U.K. and the U.S. The euro area is an equal, and recently it has been the first among equals. Over the longer term, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-6). Within the bigger picture, the euro area has underperformed through multi-year periods encompassing around half the time; and it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance was the impact of back to back recessions separated by an unusually short gap, with the second of the two recessions the direct result of policy errors specific to the euro area. In other words, the euro area's 2008-14 economic underperformance was not structural; it was cyclical. Prospects For Bond Yield Spreads And The Euro If the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends ultimately have much further to run. Unsurprisingly, relative interest rate expectations closely follow relative real GDP per head. Relative interest rate expectations 2 years out between the euro area and United States have compressed from -230 bps last December to -185 bps today. Relative interest rates expectations 5 years out have compressed more, to -150 bps today (Feature Chart). This makes perfect sense. Clearly, the ECB will not hike interest rates any time soon, but expectations for the long-term 'terminal' rate have correctly gone up from overly-pessimistic levels. Nevertheless, to reach the mid-point of its long-term cycle, the gap between euro area and U.S. interest rate expectations must ultimately get to around -50 bps (Chart I-7). The implication is that the yield spread between long-dated bonds in the euro area3 and the U.S. will also compress to around -50 bps (Chart I-8). Therefore, on a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. This also carries repercussions for euro/dollar, given that it closely tracks relative interest rate expectations. The mid-cycle gap of -50 bps equates to euro/dollar at over 1.30 (Chart I-9). And an overshoot to the top of the cycle implies over 1.50. Chart I-7Relative GDP Per Head Leads Relative Interest Rate Expectations Chart I-8...And Bond Yield Spreads Chart I-9Relative Interest Rate Expectations Drive Euro/Dollar But trends do not unfold in straight lines. They are punctuated by regular setbacks. The recent surge in euro/dollar has taken its 65-day fractal dimension towards its lower limit, which suggests excessive short-term herding. That said, we could now be at the mirror-image turning point in ECB policy to that of the summer of 2014. Then, Draghi pre-announced QE; now, he may pre-announce its demise. In which case, fundamentals will override the 65-day fractal signal just as they did three years ago (Chart I-10). Nonetheless, we would not be surprised if euro/dollar first revisited the 1.10-1.15 channel before resuming its long march upwards. Chart I-10Excessive Short-Term Herding In Euro/Dollar, But... Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In local currency terms. 2 Based on 12 month forward earnings per share. 3 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. Fractal Trading Model* This week's trade is to position for an underperformance of Chinese shares versus the emerging markets benchmark. Target a 2.5% profit target and stop-loss. 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-11 * 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. 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations