Inflation/Deflation
Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-Ã -vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-Ã -vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-Ã -vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à -vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017
Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. 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##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations
Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs Table I-2Vulnerability To BATs Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Inflation: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Yield Curve: With core inflation still low, the Fed will be quick to back away from its rate hike plans if there is any indication that inflation might reverse its uptrend. This supports a bear-steepening of the yield curve and the continued outperformance of TIPS versus nominal Treasuries. Spread Product: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Feature Chart 1A Sustainable Recovery After seven years of false starts and disappointments, a durable recovery in inflation is finally under way (Chart 1). The key difference between the current uptrend and prior episodes of rising inflation - such as those witnessed in 2011 and 2014 - is that this time around most labor market indicators suggest the economy is very close to full employment. For this reason the recovery in core inflation is likely to persist, and will eventually settle at a level close to the Fed's 2% target for core PCE. That being said, it is still far too soon for investors to worry about inflation, particularly as it relates to the performance of risk assets. The remainder of this report discusses why the recovery in inflation is likely to be slow moving, and also how the inflation outlook impacts our major fixed income investment calls. Some Near-Term Headwinds There are two reasons why year-over-year measures of core inflation are likely to moderate during the next three months. First, diffusion indexes for both CPI and PCE inflation have recently dipped below the zero line (Chart 2), meaning that more components of each index have decelerating prices than have accelerating prices. Historically, rising year-over-year core inflation has been associated with diffusion indexes above zero. Second, January and February of last year saw incredibly large price increases in both core CPI and core PCE (Chart 3). This means that gains in January and February of this year will also have to be very strong to overcome the large base effect and cause the year-over-year growth rates to move higher. Chart 2Diffusion Indexes Point To Deceleration Chart 3A Large Base Effect In Jan & Feb Now these are only very short term arguments. The base effects will be out of the way by March and diffusion indexes can reverse course very quickly. However, they do suggest that inflation readings are likely to be relatively weak during the next few months. This will be critical for the near-term path of monetary policy and, in our view, makes it likely that the Fed will keep rates steady until the June FOMC meeting. The Phillips Curve Chart 4A Phillips Curve Model Of Inflation Turning to the longer run outlook for inflation, we employ a Phillips curve model of core PCE inflation based on one that Janet Yellen referred to in a speech from September 2015.1 In this framework, the year-over-year change in core PCE inflation is modeled using: Lagged core inflation Inflation expectations (from the Survey of Professional Forecasters) Non-oil import price inflation relative to core PCE inflation Resource utilization (calculated as the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the natural rate of unemployment) The model does an excellent job capturing changes in core PCE inflation since 1990 (Chart 4), and is also useful because it gives us a glimpse of the mental framework that Fed policymakers apply to the task of inflation forecasting. Most importantly, the model allows us to generate inflation forecasts given estimates for inflation expectations, the unemployment rate and the U.S. dollar (which closely tracks relative import prices). For example, in a base case scenario where we assume that inflation expectations and the dollar remain flat, but that the unemployment rate declines from its current level of 4.7% to 4.5% by the end of this year, the model predicts year-over-year core PCE inflation will rise from its current level of 1.65% to 1.87% by November, still below the Fed's 2% target. If we keep the same forecast for a steadily declining unemployment rate but also incorporate a 5% increase in the value of the trade-weighted U.S. dollar, then core PCE inflation is projected to rise to 1.76% by November. The stronger dollar means that import prices exert a bit more of a drag. Conversely, if we keep the same unemployment assumption but assume that the U.S. dollar depreciates by 5%, then core PCE inflation is projected to reach 1.98% by November. In this scenario import prices actually provide a slight boost to core inflation. Overall, to create a scenario where core inflation reaches the Fed's target before the end of this year we need to make a fairly optimistic assumption about the unemployment rate and also incorporate a substantial dollar depreciation. In our view, it is more likely that the dollar remains under mild upward pressure this year as the U.S. economy continues to de-couple from the rest of the world. Fiscal policy remains the wildcard, as any protectionist measures implemented by the new U.S. government could lead to import price shocks. Although at first blush any watering-down of trade deals, imposition of tariffs, or protectionist tweaks to the tax code would seem likely to send import prices higher, much depends on how much of the adjustment to the new trade policy occurs through the exchange rate or through prices. This is incredibly hard to determine until the details of any protectionist trade measures are known. Our Global Investment Strategy service explored the potential ramifications of one such trade proposal - a border-adjusted corporate tax - in a Special Report published last week.2 A Bottom-Up Perspective An alternative to the Phillips curve approach is to split core inflation into its major sub-components: shelter, core goods and core services excluding shelter. We can then examine each sub-component separately and identify different macro drivers for each (Chart 5). Shelter has been the strongest contributor to core inflation so far in this recovery and can be modeled using home prices, the rental vacancy rate and household formation (Chart 5, panel 1). Based on these relationships, we expect shelter inflation will remain elevated for quite some time, while our model suggests it is even likely to move a bit higher during the next few months. After briefly seeming like it might rebound earlier last year, the rental vacancy rate has since fallen to new lows while home price appreciation continues at a steady rate of just above 4% per year (Chart 6). Further, the vacancy rate should remain under downward pressure and home prices under upward pressure as long as household formation continues to outpace home construction. The top panel of Chart 6 shows that the difference between housing starts and household formation closely tracks the rental vacancy rate. The vacancy rate rose throughout the 1990s and early 2000s as housing starts outpaced the creation of new households, but starts have not been sufficiently robust so far in this recovery. In addition, housing inventory as a percent of households is near the lows of the early 1990s (Chart 6, bottom panel). This inventory calculation includes the "shadow inventory" from foreclosed homes which has almost normalized back to pre-crisis levels, in any case. Chart 5The Components Of Core CPI Chart 6Drivers Of Shelter Inflation We expect that shelter inflation will remain elevated at least until housing construction starts to outpace the creation of new households, but will moderate once that supply response starts to emerge. Chart 7Atlanta Fed Wage Growth Tracker* ##br##Versus Unemployment Rate Core goods inflation (Chart 5, panel 2) has been, and will continue to be, the major source of deflation in this cycle. A large fraction of core goods are imported and, as such, core goods inflation tends to follow the trend in the U.S. dollar. The bull market in the U.S. dollar will continue to keep a lid on core goods prices, and will limit how quickly inflation can rise. Any meaningful increase in inflation this year is likely to come from the core services excluding shelter component, which historically tends to track fluctuations in wage growth (Chart 5, bottom panel). As we have previously highlighted, the labor market is close to full employment and the relationship between the unemployment rate and wage growth remains strong (Chart 7). In this environment, even modest further declines in the unemployment rate should exert meaningful upward pressure on wages. Bottom Line: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Investment Implications Duration & TIPS Chart 8Leading Inflation Indicators & Breakevens Long-maturity TIPS breakeven inflation rates still have upside, although the rate of increase is unlikely to maintain its current rapid pace. As core inflation converges with the Fed's target so should long-dated measures of inflation expectations such as TIPS breakevens. Historically, core PCE inflation close to 2% has coincided with long-dated TIPS breakevens in a range between 2.4% and 2.5%. With the 10-year breakeven currently at 2.05%, we expect it has another 35 to 45 basis points of upside. Measures of pipeline inflation pressure, such as producer prices and the prices paid and supplier deliveries components of the ISM manufacturing survey also point to rising breakevens (Chart 8). We continue to recommend an overweight allocation to TIPS versus nominal Treasury securities. With rate hike expectations still relatively depressed,3 real yields do not have much downside. Rising breakevens should therefore also pressure long-dated nominal yields higher in the months ahead. While we currently recommend a benchmark duration stance, we are actively looking for an opportunity to shift to below-benchmark duration, as was discussed in last week's report.4 Yield Curve As breakevens and nominal yields move higher the yield curve should also steepen (Chart 9). The strong positive correlation between the slope of the yield curve and TIPS breakevens is the result of the impact of Fed policy on both variables. Chart 9Wider Breakevens Correlated With A Steeper Yield Curve Fed policy tends to be accommodative in the early stages of a recovery, and this causes the yield curve to steepen and breakevens to widen as investors logically expect that easy money will cause both growth and inflation to move higher. In contrast, the yield curve tends to flatten and breakevens tend to fall later in the recovery once Fed policy turns more restrictive. Chart 105-Year Bullet Still Cheap Given that core inflation and TIPS breakevens both remain below the Fed's targets, it is too soon to expect a shift toward restrictive Fed policy. In other words, the Fed will be quick to back away from its rate hike plans if there is any indication that breakevens or inflation might reverse their uptrends. It is only once core inflation and TIPS breakevens have returned to the Fed's targets that the stated purpose of Fed policy will shift from supporting the recovery to snuffing out inflation. To profit from a steeper yield curve we entered a long 5-year bullet short duration-matched 2/10 barbell trade on December 20. So far this trade has returned 14 bps, and the 5-year bullet continues to look very cheap on the curve (Chart 10). Spread Product In prior research we considered the performance of spread product throughout the four phases of the Fed cycle (Chart 11).5 We define the four phases of the Fed cycle as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Chart 11Stylized Fed Cycle Using a very simple estimate of the equilibrium fed funds rate based on potential GDP and a long-run moving average of the funds rate itself, we have found that excess returns to investment grade corporate bonds are highest in phase IV and phase I, when the fed funds rate is below equilibrium (Table 1). However, the key problem with this analysis is that it is very difficult to estimate the equilibrium fed funds rate in real time. As stated above, the estimate used in Table 1 incorporates the CBO's estimate of potential GDP which is frequently revised after the fact. So while we are confident that we are currently in phase I of the Fed cycle, the challenge becomes looking for other indicators that might warn us about the transition from phase I to phase II, where excess returns are much worse. We have found that core PCE inflation is one such indicator. We calculated average monthly excess returns to investment grade corporate bonds when year-over-year core PCE inflation is below 1.5%, between 1.5% and 2%, and between 2% and 2.5% (Table 2). Table 1Investment Grade Corporate Bond Excess Returns* Under The Four Phases##br## Of The Fed Cycle (August 1988 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## For Year-Over-Year Core** PCE (August 1988 To Present) The results show that the highest returns occur when inflation is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with phase IV of the Fed cycle. We found mixed results for when inflation is between 1.5% and 2%. In this environment average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. This environment likely encompasses phase I of the Fed cycle and the transition into phase II. It is not until core PCE inflation is above 2% that excess returns turn decisively negative. Monthly excess returns average -13 bps in this environment, with a 90% confidence interval of -35 bps to +10 bps. With inflation likely to remain between 1.5% and 2% for the balance of the year, it is too soon to turn all-out bearish on spread product. For the moment we recommend a neutral allocation, but with an underweight allocation to high-yield bonds where valuations are exceedingly tight. Given that inflation is low and Fed policy is accommodative, we would be quick to upgrade both investment grade and high-yield corporates on any near-term sell off. The current uncertainty surrounding fiscal policy also complicates the outlook for spread product. On the one hand, it raises the risk of a near-term sell off if it appears as though some of the more stimulative aspects of Trump's agenda will not be implemented. On the other hand, in addition to headline-grabbing promises of increased infrastructure spending, there are many other policy details that could also have significant market implications. One example would be the elimination of the tax deductibility of corporate interest expenses. Such a provision is currently included in the Republican's plan for corporate tax reform, and would severely diminish supply in the corporate bond market if it is implemented. Bottom Line: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see Global Investment Strategy, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at gis.bcaresearch.com 3 The overnight index swap curve is priced for 54 basis points of rate hikes during the next twelve months. 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy / U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms. It is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. The "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. There is a strengthening case for cyclical improvement in manufacturing investment. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Feature Investors will be paying close attention to President-elect Donald Trump's inauguration speech this coming Friday, which may allow for a clearer understanding of his world view and economic policies, as well as their global implications. The inauguration will overshadow China's key economic statistics to be released later this week, and which we expect to show that the Chinese economy has picked up sequentially. As political uncertainty will stay elevated and deserves close monitoring going forward, it is equally important to keep in mind the economic big picture. In the next two months, China's economic data will once again be heavily distorted by the Chinese New Year holiday, making it more difficult to detect genuine growth trends. In last week's report, we laid out our view on China's growth and policy outlook for 2017.1 This week, we offer a reality check and our take on some key cyclical issues. Watch For Inflation Surprises The biggest change in China's macro condition in the past year, in our view, has been the sharp turnaround in producer prices. Rising PPI has lifted corporate pricing power, reduced real interest rates and eased financial stress in some heavy industries, the weakest link in the corporate sector - all of which are important reasons behind China's growth improvement of late. Looking forward, we expect inflation will remain well behaved. Improving producer prices is to a large extent attributable to RMB depreciation, which has already begun to crest. The trade-weighted RMB's depreciation has halted, and it is unrealistic to expect it to continue to depreciate at an ever-accelerating pace (Chart 1). This should cap the upside of PPI inflation. The headline consumer price index (CPI), the broader inflation measure, was fairly stable throughout last year's roller coaster ride in PPI (Chart 2). Moreover, the fluctuation in headline CPI was mainly attributable to food prices, which have been noisy due to seasonal factors and unexpected supply-demand disruptions, but have been largely trendless in recent years. There is no case for a food-induced inflation outbreak. Chart 1PPI Inflation Is Peaking Chart 2No Case For Food Inflation More fundamentally, although the Chinese economy has strengthened, it is still operating below potential. Historically, runaway inflation has always occurred when the economy overheated, which is far from the current situation (Chart 3). Without a strong growth rebound, it is difficult to expect genuine inflationary pressures. In short, the current environment is best characterized as "easing deflation" rather than "rising inflation," and our base case remains that inflationary pressures will stay at bay. Nonetheless, it is important to note that strong deflationary pressures have prevailed since the global financial crisis, which has led to major adjustments in the world economy. In China's case, for example, capital spending has slowed sharply. Meanwhile, cutting excess capacity has been an explicit policy priority, which, together with strengthening demand may lead to a quick rise in prices. Last year's sharp rebound in steel, thermal coal and some other raw materials prices provided clear evidence of this. Indeed, several factors warn against being overly complacent about the inflation outlook. For producers, the improvement in pricing power appears rather broad based, as both industrial firms and the service sector have been reporting rising levels in their respective output prices. In other words, rising prices are not just contained in resource sectors associated with global commodities prices and Chinese capacity cuts. For consumers, inflation expectations have begun to rise (Chart 4). Consumers' inflation expectations may be just a response to changes in prices rather than a leading indicator for future price moves. However, there has been a significant pickup in confidence on future income growth, which is likely a reflection of a tighter labor market and rising wages. If this trend holds, it would make it a lot easier for producers to pass through rising input costs to end users. Chart 3Inflation Vs Economic Overheating Chart 4Inflation Expectations Are On The Rise Overall, it is premature to worry about an inflation outbreak, and we do not consider inflation as a major policy constraint for the People's Bank of China. However, it appears that deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms, supercharged by both improvement in real activity and a rising GDP deflator. Nominal GDP may reclaim a double-digit annual pace in the coming quarters. Exports: Why Has The Historical Correlation Broken Down? China's latest export numbers continued to disappoint, falling by 6.1% in dollar terms from a year ago. Part of the decline is due to falling prices measured in dollar terms; exports in volume terms are considerably stronger. Nonetheless, the export sector has been a chronic underperformer in the Chinese economy in recent years. Historically, China's export sector performance was highly predictable based on some key domestic and global variables - this correlation has clearly broken down since 2015 (Chart 5). If the historical correlation still held, export growth should have rebounded sharply. Many have viewed the divergence as a sign that Chinese exporters have lost competitiveness, which does not seem credible, as Chinese exports have continued to gain global market share. In our view, the chronic disappointment of the Chinese export sector's performance is due to several factors. First, the global financial crisis was a watershed event that marked structural breaks in economic correlations. Since then, consumers in the developed world have been focusing on deleveraging and fixing their balance sheets, and therefore the growth recovery has not led to a corresponding increase in demand - and imports for - consumer goods. Second, protectionist pressures have been on the rise since the global financial crisis, as all countries have tried to protect domestic producers in the face of weak final demand. Anti-dumping measures initiated by World Trade Organization member countries have increased notably in recent years, a growing share of which have been targeted at Chinese exporters (Chart 6). The high profile anti-dumping measures adopted by the Obama administration against Chinese tire and steel products have caused significant damage to Chinese producers and exporters.2 Chart 5Exports Have Disappointed Chart 6Protectionism Is Already On The Rise Finally, Chinese export numbers have been distorted by disguised capital flows driven by speculation on the RMB exchange rate. The sharp swings in Chinese exports to Hong Kong since the global financial crisis can be viewed as proxy for shifting expectations on the yuan (Chart 7). Immediately after the global financial crisis, the RMB was widely expected to rise against the dollar, leading to a massive surge in Chinese sales to Hong Kong as exporters overstated export revenues to bring more foreign currencies onshore. The tide completely reversed in early 2014 when the RMB began to drop against the greenback. Exporters may have been underreporting overseas sales so they could park part of their foreign revenues offshore in anticipation of a weaker RMB, weighing on overall export sector performance. Whatever the reason, the important point here is that it is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. In recent years the Chinese authorities systematically overestimated the vigor of global demand, and export sector performance almost always lagged the government's annual targets, which contributed to chronic growth disappointments. In this regard, the "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. Has Investment Bottomed? With exports chronically disappointing, domestic capital spending holds the key for economic growth. Policy driven investment on infrastructure construction has held up strongly since 2013, while private sector investment mainly in the mining and manufacturing sectors has downshifted sharply. Looking forward, infrastructure spending will likely remain buoyant, supported by both public budgetary sources and public-private-partnerships (PPPs).3 What's changing is that capital spending in the manufacturing sector may have bottomed from a cyclical point of view. Inventory destocking in the manufacturing sector has become very advanced. Improving new orders and rising producer prices should lead to a restocking cycle. There has been a notable improvement in corporate sector profitability and confidence of late, which has historically led capital spending in the manufacturing sector (Chart 8). Consistently, the latest credit numbers show a significant pickup in medium- and long-term loans by the corporate sector, which are typically used to finance investment spending rather than replenish working capital. Chart 7Hong Kong Trade And The RMB Chart 8Manufacturing Capex Has Bottomed The long-term outlook for Chinese private capital spending hinges critically on structural reforms on many fronts. As far as the corporate sector is concerned, it is widely recognized that China's overall tax burden is not high by global standards, but is primarily shouldered by the corporate sector rather than households, and a rebalancing is long overdue. The government under incumbent Premier Li Keqiang has been focusing on reducing administrative red tape and mandatary employee benefits provided by employers as ways to cut corporate sector costs. If the Chinese authorities can implement reforms despite the populist resistance to shifting some of the tax burden from the corporate sector to households, it could further boost corporate profitability and revive animal spirits among Chinese entrepreneurs, leading to another round of investment boom. Any tax reform measures in this direction should be viewed as a major positive development. For now, we see a strengthening case for cyclical improvement in manufacturing investment, after decelerating for over six years. The current sub-par "new normal" growth trajectory rules out a sharp revival in capex, but the marginal change in "second derivatives" is still important as it diminishes a chronic growth headwind. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1, 3 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations