Asset Allocation
Highlights The USD remains supported by fundamentals, especially now that its late-2016 excesses have been purged. Solid U.S. growth contrasts with weaker growth in the rest of the world, which will incentivize further inflows into the U.S. dollar. Despite this positive cyclical view, the tactical outlook remains risky for dollar bulls. In the immediate term, the euro will benefit from easing Italian tensions and as well as from the dollar's correction, but its six-month outlook remains poor. The AUD could also rebound right now, but any such rally should be used to build further short positions. Feature After a furious rally from February to August, the dollar has been weakening since the middle of last month. Since July, we have been worried that the dollar could stage a bit of a correction,1 but we remained committed to the view that ultimately the greenback would rise further in 2018. It is now time to review whether this thesis still holds. BCA believes that the USD's correction could run through the fall, but that the final quarter of 2018 should still prove a rewarding period for dollar bulls. Ultimately, policy divergences will remain a crucial support for the dollar, especially as EM weakness continues to affect the distribution of growth across the globe. USD: Not Yet Extended The dollar ultimately follows the path implied by its fundamental drivers - whether they are interest rate spreads, growth and inflation differentials, relative equity prices, or even relative money-supply growth. However, the path taken by the USD around its drivers is rather wide, and the dollar regularly overshoots and undershoots the equilibrium implied by the aggregation of all these fundamentals (Chart I-1). Academics call this the "band of agnosticism." Chart I-1The Dollar To Follow Fundamentals Higher This cycle was no exception. BCA's Fundamentals Index for the dollar hooked up in 2011, a move associated with a turning point in the greenback itself. However, the dollar remained in undershoot territory for many years. Then suddenly, in 2014, the coiled spring was released and the dollar surged higher, moving above its "band of agnosticism" in 2015 - a moved exacerbated by the sudden rally that followed the election of Donald Trump in November 2016. Once the dollar had become over-loved, over-owned and expensive, it also became vulnerable. The pick-up in global growth that was so evident in 2017 caused a serious correction in this vulnerable currency. However, the selloff had a positive impact: U.S. growth, interest rates, equities and so on continued to move favorably, and the dollar is now positioned to rebound anew, having purged its most egregious excesses. The global economic backdrop is also positive for the dollar. For one, the theme of monetary divergences is still at play. Boosted by a healthy banking sector, healthy household balance sheets and an untimely fiscal stimulus of 1.7% of GDP, U.S. growth has hit 2.8%, well above potential. Moreover, growth has been above potential for eight years, and now U.S. capacity utilization is at its tightest level since the late 1980s. Historically, so large an absence of slack has been linked to higher U.S. interest rates (Chart I-2). Yet interest rate markets are pricing in roughly four increases over the next 24 months, even as Lael Brainard warned that the Federal Reserve could move beyond the hikes implied by its own forecast, the "dot plots." Chart I-2Tight Capacity Utilization Implies Higher U.S. Rates... The U.S. economy continues to fare well, as U.S. real interest rates remain 60 basis points below neutral rates and the yield curve has yet to invert. However, U.S. rates matter for the rest of the world as well. There, the picture is less pretty. EM dollar debt stands near record levels (Chart I-3). Hence, EM financial conditions have been hit by the combined assault of higher U.S. rates and an appreciating dollar. Nowhere is this clearer than when looking at the interplay between U.S. bond yields and the South African rand or AUD/JPY, a cross highly correlated to EM currencies. This cycle, rising U.S. bond yields have most often been associated with a rising ZAR or a rising AUD/JPY (Chart I-4). However, this time around, as was the case during the May 2013 Taper Tantrum, rising bond yields are linked to these pro-cyclical currency pairs falling. This suggests that rising yields are not reflecting global growth anymore, and are in fact restrictive for the rest of the world, even if they are not a problem for the U.S. Chart I-3... Which Will Hurt EM Economies Chart I-4Higher U.S. Rates Now Hurt Global Growth This inference is underpinned by the decline in BCA's U.S. Financial Liquidity Index, which heralds additional weakness in global growth and commodity prices (Chart I-5). Already we are seeing symptoms of the malaise. Japanese foreign machine tool orders are contracting, and BCA's Asian Leading Economic Indicator is in deep contraction (Chart I-6). Chart I-5Dollar Liquidity Is A Problem For Growth Chart I-6Signs That Global Growth Is Already Suffering A rising fed funds rate and falling ex-U.S. growth is likely to continue to support the dollar. The dollar loves nothing more than falling global growth. The U.S. economy has low exposure to global trade and to the global industrial sector, and therefore when global growth slows, the U.S. economy is relatively insulated from foreign shocks. This means that U.S. rates of return do not suffer as much as foreign ones. This is even truer in the rare instances when global growth slows while U.S. economic activity continues to power ahead, especially when artificially inflated by untimely fiscal stimulus. This is a characterization of the current environment. Hence, money will continue to flow into the U.S. economy on a two- to three-quarter horizon. In fact, portfolio flows into the U.S. remain well below the levels that prevailed during the previous decade (Chart I-7). The current account deficit is also smaller, hence, if net foreign portfolio flows can increase due to the attraction of higher U.S. rates of return, the U.S. balance of payments will move into a greater surplus, creating a strong underpinning for the dollar. This positive cyclical backdrop for the greenback is not without impediments. Most crucially are the short-term dynamics. Since July, we have been warning clients that a tactical correction in the dollar was likely. While EUR/USD has indeed rebounded, most other currencies have displayed rather tepid performances. This does not mean that the tactical risks to the dollar have abated. Quite the opposite, they are rising. As Chart I-8 illustrates, a large buildup in dollar longs has materialized, yet the G10 economic surprise index is making a trough. Moreover, the diffusion index of the BCA Global Leading Economic indicator is also stabilizing. Additionally, USD /CNY has failed to make new highs and the Turkish central bank just raised rates to 24% - which if Argentina is any guide is likely to provide only temporary relief for the TRY. This means that a period of risk-on sentiment in EM could emerge. Stretched dollar positioning, a temporary stabilization in global growth and EM inflows could precipitate a serious correction in the dollar. Chart I-7Dollar Favorable Flows Chart I-8Tactical Risks To The Dollar Bottom Line: The dollar is still supported by potent cyclical tailwinds. The U.S. economy is roaring and at full employment, yet global growth is suffering because global liquidity conditions are deteriorating. Higher rates of return in the U.S. will therefore attract additional capital, supporting the greenback in the process. Despite this positive cyclical backdrop, the short-term outlook is murkier. Speculators have aggressively bought the dollar, leaving them vulnerable to any positive surprises in global growth, even temporary ones. Fade The Euro Rebound The euro has benefited from the cool-off in Italian politics. The populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels, as Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit, while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. As a result, the spread between Italian BTPs and German bunds has fallen from 193 basis points at the beginning of the month to 150 basis points this week (Chart I-9). Since gyrations in Italian spreads reflect the evolution of the perceived probability that the euro area will fall apart, the fall in the spreads has implied a fall in the euro area-breakup risk premium. This has created a boon for the euro. Another support for the euro emerged yesterday. At his press conference, European Central Bank President Mario Draghi divulged that the ECB has curtailed its growth forecast for 2018 and 2019, but not its inflation forecast. In fact, Draghi went as far as mentioning that his confidence that euro area inflation would move back to target in the medium term has increased. There is no denying that the inflationary backdrop has improved as European wages and labor costs have indeed starting to recover (Chart I-10). However, the picture is not that straightforward. The lagged impact of the previous fall in euro area inflation relative to the U.S. is likely to continue to be felt in EUR/USD moving forward, as has been the case over the past 10 years (Chart I-11). Chart I-9The Euro Area Break Up Risk Premium Is Declining Chart I-10Rising Euro Area Labor Costs Chart I-11Relative Inflation Backdrop Is Still Euro Bearish This risk is compounded by developments in China. As we have often argued, the growth differential between the euro area and China can largely be explained by growth dynamics in China. As Chart I-12 illustrates, when Chinese monetary conditions tighten, or when China's marginal propensity to consume - as approximated by the gap between M1 and M2 - declines, this often leads to underperformance of European economic activity relative to the U.S. Chart I-12AChinese Economy Still Hurting Euro Area Vs U.S. (I) Chart I-12BChinese Economy Still Hurting Euro Area Vs U.S. (II) Today, Chinese monetary conditions have improved somewhat as the Chinese authorities try to combat the shock to the Chinese economy created by the growing trade war between the U.S. and China. However, Matt Gertken, BCA's Geopolitical Strategy service's expert on Chinese policy, believes that Chinese policymakers do not intent to actually cause economic growth to pick up. Indeed, they are committed to reform and deleveraging, and only want to limit downside to the Chinese economy.2 Thus, the large growth gap between the U.S. and the euro area is here to stay. As markets absorb news of Chinese stimulus, EUR/USD could rebound toward 1.19, but we are inclined to fade such a rebound. For one, the growth and inflation gap between the U.S. and the euro area remains euro bearish. Additionaly BCA's Central Bank Monitor for the Fed clearly points toward the need to tighten U.S. monetary policy, while our indicator for the ECB points to the need to maintain an extremely loose policy setting in Europe (Chart I-13). With the euro still trading above its intermediate-term fair value estimate (Chart I-14), beyond any short-term rally the euro still possesses ample downside in the fourth quarter. As such, we would use the current rebound in the euro as an opportunity to buy the dollar once again. Chart I-13The U.S. Needs More Tightening, Europe Does Not Chart I-14The Euro Possesses Downside Bottom Line: Falling risk premia in Italy, a pick-up in European wages and signs of stimulus in China are creating some support under the euro. However, European growth and inflation are set to continue to lag well behind the U.S. as China's stimulus is not designed to reverse its deleveraging campaign and boost growth, but instead to limit downside to growth created by the U.S.-China trade war. Hence, we will use the current rebound in the euro and correction in the USD to buy the greenback again in the coming weeks. What's Going On Down Under? In recent months, the Australian economy has managed to generate some impressive numbers on the employment front. However, until recently this was not enough to prompt investors to push the AUD higher. In fact, as recently as Monday, AUD/USD was trading at 0.71. Investors are skeptical about the Australian economy's underlying strength. The NAB Business Confidence for the Next Period has weakened sharply, while mortgage approvals and house prices have also sagged. This suggests that new orders, employment and consumption could follow lower (Chart I-15). This represents a big problem for the Aussie, as our central bank monitor for the Reserve Bank of Australia is already in "easing required" territory (Chart I-16). The RBA will therefore not be able to hike rates any time soon, despite the fact that U.S. interest rates are currently in an uptrend. As such, interest rate differentials between Australia and the U.S. will continue to deteriorate. Chart I-15Australia Is Set To Slowdown Chart I-16China And Australia Are Joined At The Hip Moreover, Australia has been hit directly by the decline in Chinese industrial activity. As Chart I-17 illustrates, Australian exports are a direct function of China's Li-Keqiang index. This has two implications. First, the current rebound in the Li-Keqiang index suggests that investors could bid up the AUD with great alacrity if the USD were to correct further, a thesis we espouse. However, since we do not anticipate the rebound in the Li-Keqiang indicator to have much longevity, nor do we anticipate the greenback's correction to morph into a bear market, this also means that we would use any rebound in the AUD to sell more of it. Beyond China, EM at large still constitutes a risk for AUD/USD. Arthur Budaghyan, our Chief EM strategist, argues that the period of weakness in EM assets has further to run. Our views on the U.S. dollar, on declining global liquidity and on Chinese policy corroborate this assessment. If EM economies slow further, the still-elevated expected long-term growth rate in EM earnings could decline further as well. Since growth expectations on EM EPS are indicative of expected interest rates and terms-of-trade for Australia, this also suggests that the AUD could suffer significant downside in the coming quarters (Chart I-18). Finally, the AUD remains a pricey currency. AUD/USD continues to trade significantly above its purchasing-power-parity fair value, and the real trade-weighted AUD remains above its long-term average (Chart I-19). As such, the AUD does not possess the required valuation cushion to make it a buy in this challenging context. Chart I-17RBA ##br##Cannot Hike Chart I-18EM Has Yet To Be Fully Re-Rated, ##br##And So Does The AUD Chart I-19No Valuation Cushion##br## In The AUD Bottom Line: The Australian economy has posted some solid employment numbers, but the trends in business confidence and the housing market augur poorly. Australian monetary policy will have to remain very loose. Moreover, since China's stimulus is likely to be limited, any rebound in the AUD on the back of a dollar correction should be faded, especially as the Aussie does not offer any valuation cushion. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Time To Pause And Breathe", dated July 6, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "China: How Stimulating is The Stimulus?", dated August 24, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Average hourly earnings growth outperformed expectations significantly, coming in at 2.9%. Moreover, nonfarm payrolls also surprised to the upside, coming in at 201 thousand, but this was mitigated by large downward revisions to the previous two months. Additionally initial jobless claims surprised positively, coming in at 203 thousand. However, core inflation underperformed expectations, coming in at 2.2%. Finally, DXY has been flat for the past couple of weeks. We continue to be bullish on the dollar on a cyclical basis, as inflationary pressures will continue to accumulate in the U.S., causing the fed to hike more than expected, particularly in 2019. Moreover, high U.S. borrowing cost will likely weigh on global growth, giving an additional boost to the dollar, as the U.S. has a lower beta than other DM economies to the global economic cycle. Report Links: The Dollar And Risk Assets Are Beholden To China’s Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the euro area has been negative: Both headline and core inflation surprised to the downside, coming in at 2% and 1% respectively. Moreover, industrial production yearly growth also surprised to the downside, coming in at -0.1%. Finally, retail sales yearly growth also underperformed expectations, coming in at 1.1%. EUR/USD has been flat the past two weeks. Yesterday, however the market rallied as the ECB confirmed that it expects to wind down its bond-buying program. Nevertheless, it also lowered growth forecast for this year and next. We continue to believe that the euro will have downside until the end of the year, as a policy and regulatory tightening in China will weigh on the global industrial cycle, to which Europe is highly levered. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: Tokyo ex fresh food inflation outperformed expectations, coming in at 0.9%. Moreover, overall household spending yearly growth also surprised positively, coming in at 0.1%. However, labor cash earnings yearly growth underperformed expectations substantially, coming in at 1.5%. Finally, Markit Services PMI surprised to the downside, coming in at 51.5. USD/JPY has been flat the past couple of weeks. Overall, we are bullish on the yen against the euro and the commodity currencies, as the tightening in monetary policy in the U.S. as well as in China should create a risk off environment where safe heavens like the yen benefits and cyclical currencies suffer. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been mixed: Average hourly earnings yearly growth excluding and including bonuses both came in above expectations, at 2.9% and 2.6% respectively. Moreover, Markit Services PMI also outperformed expectations, coming in at 54.3. However, industrial production surprised to the downside, coming in at 0.9%. Finally, nationwide housing prices yearly growth also surprised negatively, coming in at 2%. GBP/USD has rallied by roughly 0.5% the past couple of weeks. We believe that the pound could have some short term upside, as positioning continues to be significantly bearish. That being said, we are bearish on the pound on a cyclical basis, particularly against the yen. At this moment, the pound does not appear to have much of a geopolitical risk premium embedded in its price. Thus, any turbulence in the Brexit negotiations could result in significant downside for the GBP. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Gross domestic product yearly growth came in above expectations, at 3.4%. However, building permits month-on-month growth surprised to the downside, coming in at -5.2%. Finally, the RBA Commodity Index SDR yearly growth surprised positive, coming in at 6.7%. After a bout of pronounced weakness, AUD/USD has been flat for the past couple of weeks. We believe that the Australian dollar has further downside particularly against the yen and the dollar. Australia's economy is very sensitive to the Chinese industrial cycle, as iron ore is Australia's main commodity export. However, the overleveraged industrial complex is precisely the economic sector where Chinese policymakers want to rein in credit excesses. This will curb industrial activity in China, and hurt the economies of commodity supplies like Australia. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar Recent data in New Zealand has been mixed: Retail sales and retail sales ex autos yearly growth both outperformed expectations, coming in at 1.1% and 1.4% respectively. Moreover, the trade balance also surprised to the upside, coming in at -4.4 billion dollars/ However, the terms of trade Index underperformed expectations, coming in at 0.6%. NZD/USD has fallen by roughly 0.8% against the dollar for the past couple of weeks. We continue to be bearish on kiwi on a cyclical basis. The combination of high U.S. rates and deleveraging in China will weigh on carry currencies like the NZD. Furthermore, we also hold a bearish view on a structural basis, given that the new government has vowed to curb immigration and add an unemployment mandate to the RBNZ, both developments which are negative for the currency. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Both core and headline inflation outperformed expectations, coming in at 1.6% and 3% respectively. Moreover, manufacturing shipments month-on-month growth also outperformed expectations, coming in at 1.1%. However, retail sales month-on-month growth surprised to the downside, coming in at -0.2%. USD/CAD has been flat for the past couple of weeks. We are short this cross as a hedge to our dollar bullish view, as inflationary pressures in Canada remain strong. Moreover, the CAD will continue to outperform the AUD, as the divergence between Canada's and Australia's main export markets- China and the U.S. - will persist. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc Recent data in Switzerland has been mixed: Gross domestic product yearly growth outperformed expectations, coming in at 3.4%. The SVME PMI also surprised to the upside, coming in at 64.8. However, the KOF leading indicator surprised negatively, coming in at 100.3. Finally, real retail sales growth also underperformed expectations, coming in at -0.3%. EUR/CHF has risen by roughly 0.5% this past two weeks. We continue to be bearish on the franc on a long-term basis, as inflationary pressures in Switzerland are still too weak for the SNB to remove its accommodative monetary policy, or stop its currency intervention. That being said, the CHF could experience some short term upside if the sell-off in emerging markets continues. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone Recent data in Norway has been mixed: Both headline and core inflation outperform expectations, coming in at 3.4% and 1.9%. Moreover, the Labour Force survey also surprised to the upside, coming in at 3.9%. However, retail sales growth underperformed expectations, coming in at 0.7%. USD/NOK has fallen by nearly 2% over the last two weeks. We are bullish on the NOK against other commodity currencies like the AUD and the NZD. This is because oil will likely outperform within the commodity space. After all, Our commodity strategist have explained at length why political risk in Iraq and Venezuela could cause a shortage of supply in the oil markets, while Chinese deleveraging in the industrial sector will weigh on base metal demand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at -1.2%. However, consumer confidence outperformed expectations, coming in at 102.6. The krona has been the best performing currency during the past two weeks, with USD/SEK falling by roughly 2% over this period. At the moment we continue to be bullish USD/SEK, as the krona is the most sensitive currency to the dollar's strength. However, on a longer term basis, we believe that inflationary pressures in Sweden will ultimately force the Riskbank to hike more than the market expects, providing support for the SEK. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights An inflation scare would initially take bond yields higher. But the higher bond yields would undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, an inflation scare could unleash a potentially much larger disinflationary scare. And the subsequent decline in yields would exceed the original rise. Using the 10-year T-bond yield for our roadmap (because it is least impacted by the lower bound to yields) a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Feature The global long bond yield has been trapped within a tight sideways channel for almost two years (Chart of the Week); the global equity market has also lacked any clear direction in recent quarters (Chart I-2). The result is that this year's defining feature for asset-class returns is that there is no defining feature! Global equities, bonds and cash have delivered near-identical returns.1 Chart Of The WeekThe Global Long Bond Yield ##br##Has Been Trapped Chart I-2World Equities Have Drifted ##br##Sideways This Year This is not to say that 2018 has been a dull year for investors. Far from it. But all the action has been underneath the main asset allocation decision, across sectors, regions and countries. For example, European healthcare has outperformed European banks by 35 percent; and developed market equities have outperformed emerging market equities by 15 percent (Chart I-3 and Chart I-4). Chart I-3The Main Action Has Been Across Sectors... Chart I-4...And Across Regions Unshackling Bond Yields Might Be Difficult In the major developed economies, unemployment rates keep hitting new generational lows, implying that the main labour markets are tight. Yet policy interest rates range from a crisis-level negative 0.4 percent in the euro area to just 0.75 percent in the U.K. to a modest 2 percent in the U.S. This raises the potential for an inflation scare. At any moment, the bond market might panic that central banks are well behind the (Phillips) curve.2 The spike in bond yields would of course unleash a countervailing disinflationary feedback, by cooling credit growth and credit-sensitive sectors in the economy. But this feedback would take weeks or months to take effect and to show up in the economic data. Until then, it would liberate bond yields to reach higher ground. However, there would be a more powerful and immediate feedback which would keep the shackles on bond yields. That feedback would come not from the economy, but from the financial markets themselves. In Finance 101, all investment students learn that the valuations of risk-assets depend (inversely) on bond yields. But what is less well understood is that at very low bond yields this relationship becomes exponential. Approaching the lower bound of bond yields, bonds become doubly ugly. Not only do they offer feeble returns, but the bond returns take on an unattractive asymmetry. Specifically, you can no longer make a sudden large gain, but you can still suffer a sudden deep loss. In effect, bonds become much riskier investments.3 Confronted with this increased riskiness of bonds, 'risk-assets' becomes a misnomer because risk-assets are no longer riskier than bonds! This requires risk-asset returns to collapse to the feeble return offered by bonds with no additional 'risk-premium', giving their valuations an exponential uplift (Chart I-5). The big problem is that if bond yields normalise, the process goes into sharp reverse - the lofty valuations of risk-assets must decline as exponentially as they rose. Chart I-5At Low Bond Yields ##br##The Valuation Of Equities Changes Exponentially The global bond yield appears close to this crossover point at which risk-asset valuations become vulnerable to an exponential derating. In the past year, whenever the global bond yield has reached the upper limits of its recent range - defined by the sum of 10-year yields on the U.S. T-bond, German bund, and JGB reaching 3.5 percent - the correlation between bond yields and equities has turned sharply negative (Chart I-6). And the subsequent sell-off in equities has eventually pegged back the rise in bond yields, effectively trapping them. Chart I-6At Higher Bond Yields The Correlation With Equity Prices Has Flipped From Positive To Negative But what would happen if there were an inflation scare? The answer depends on the relative sizes of the inflationary impulse compared with the disinflationary impulse that resulted from sharply lower risk-asset prices. If central banks were more concerned about the inflationary impulse, they would have to keep tightening - in which case, bond yields would be liberated to reach elevated territory. Conversely, if the bigger worry was the disinflationary impulse, central banks would quickly reverse course, and bond yields would return to the lowlands. We now explain why the disinflationary impulse from lower risk-asset prices would end up as the bigger worry. An Inflation Scare Would Be Disinflationary The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets and preceded the emerging market credit boom (Chart I-7). Chart I-7The Emerging Market Boom Happened After 2008 By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes - global equities (Chart I-8), global credit (Chart I-9), and global real estate. This makes it considerably more dangerous, because we estimate that the total value of global risk-assets is $400 trillion, equal to about five times the size of the global economy. Chart I-8Elevated Valuations On Global Equities Chart I-9Elevated Valuations On Global Credit Let's say you had an investment that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today's price must surge by 63 percent.4 If you were prudent, you might amortise today's windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. Now let's imagine a valuation derating moves the investment's returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The key takeaway is that any inflationary impulse would - through higher bond yields - undermine the valuation support of global risk-assets worth several times the size of the global economy. Thereby, it could unleash a potentially much larger disinflationary impulse. A Roadmap For An Inflation Scare The high sensitivity of risk-asset valuations to bond yields is the genesis of our 'rule of 4' strategy for equity allocation, which is based on the sum of the 10-year yields on the U.S. T-bond, German bund and JGB: Above 3.5 is the level to go to a neutral exposure to equities; above 4 is the level to go underweight. Today, our metric stands at exactly 3.5 (Chart I-10). Chart I-10The 'Rule Of 4' Is At 3.5 For bonds, this means that 4 on this metric is also a good level to buy a mixed portfolio of high-quality 10-year government bonds. The equivalent level for high-quality 30-year government bonds is 5.5 (using the sum of the three 30-year yields). To sum up, an inflation scare would initially take bond yields higher. But this would threaten to unleash a much larger disinflation scare, causing the subsequent decline in yields to exceed the original rise. Using the 10-year T-bond yield as an illustration - as it is least impacted by the lower bound to yields - this would suggest the following roadmap: a short trip to the uplands of 3.5% would precede a longer journey down to 2%. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The global long bond yield is captured by the simple average of the 30-year yields on the U.S. T-bond, German bund and Japanese government bond (JGB). The global equity market is captured by the MSCI All Country World Index in local currency terms. 2 The -0.4 percent refers to the ECB deposit rate. 3 Please see the European Investment Strategy Weekly Report "The Rule Of 4 For Equities And Bonds," August 2, 2018, available at eis.bcaresearch.com. 4 5 percent compounded over ten years. Fractal Trading Model* This week’s recommended trade is an intra-commodity pair trade: short palladium/long copper. The profit target is 6% with a symmetrical stop-loss. In other trades, short euro area energy versus financials was closed at the end of its 65 trading day holding period, albeit in loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights U.S. Treasuries: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Contagion: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 2014/2015 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Feature Chart of the WeekBond Yields Following Inflation & QT, Not EM Have investors become too complacent? The selloff in emerging market (EM) assets is intensifying. The White House is threatening to slap tariffs on virtually all Chinese imports in the U.S. Accelerating wage and price inflation in the U.S. is keeping Fed rate hikes in play. The divergence between the strong U.S. economy and the rest of the world is growing wider, keeping the U.S. dollar elevated. Yet despite all that, non-EM markets show a surprising lack of concern over the EM volatility. U.S. equity indices remain close to all-time highs, while corporate bond spreads in the major developed markets are generally stable. Government bond yields remain well above levels implied by measures of economic sentiment like the global ZEW expectations index (Chart of the Week). For yields, the big issue remains, as always, the outlook for inflation and monetary policy. On that note, yields are being supported by inflation expectations, which have been boosted by faster realized inflation, tight labor markets and high oil prices. These trends are most pronounced in the U.S., where the Fed is not only hiking rates but also slowly reducing the size of its swollen balance sheet. This comes on top of the diminished pace of asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ), with the former still on track to end its net new buying of bonds at the end of the year. Against that backdrop of rising inflation and tightening global liquidity conditions, it is incorrect to solely make comparisons between today and the most recent period of EM weakness in 2014/15 that eventually spilled back violently into non-EM markets and caused the Fed to pause after only its first post-QE rate hike. The current backdrop also has similarities to the 2013 "Taper Tantrum", when the Fed surprised the markets by signaling that it was considering ending QE, triggering a spike in Treasury yields and a selloff in global risk assets. Chart 2China Remains The Key To Global Growth Then, global growth was accelerating and inflation expectations were at levels consistent with policymaker targets in the U.S. and Europe, yet central bank liquidity was slowing rapidly (mostly due to a contracting ECB balance sheet at a time when the Fed's balance sheet growth had already slowed). EM markets sold off alongside the rapid rise in U.S. Treasury yields during the Taper Tantrum. Yet with global growth accelerating and the U.S. dollar staying relatively stable, the EM selloff ended when the Fed delayed the start of the taper into 2014, providing a monetary boost to a global economy that did not need it. Today, realized inflation is even faster and central bank liquidity is again slowing rapidly. Yet market-based inflation expectations are still a bit below central bank targets, while non-U.S. growth expectations are slowing. Worries about the impact on the world economy from the brewing U.S.-China trade war are clearly weighing on the latter. The wild card will be how China responds to the tariff threat through policy stimulus. Already, China's policymakers have allowed some depreciation of the renminbi, along with some modest easing of monetary and fiscal policies, to counteract the growth threat from the Trump tariffs. BCA's China experts do not expect anything close to the massive 2015/16 package of fiscal/monetary stimulus, given the stated goal of President Xi Jinping to crack down on systemic financial risk.1 Yet the most recent figures on Chinese import growth, and higher-frequency data incorporated in the Li Keqiang index, are showing some reacceleration after the 2017 slowdown (Chart 2). At the same time, the most recent data point on the OECD's global leading economic indicator is potentially stabilizing (middle panel). A continuation of these trends could help reverse the cooling of non-U.S. growth seen so far in 2018 (bottom panel). Given all the uncertainties surrounding the U.S.-China trade battle, EM volatility and Chinese growth - at a time when global QE has turned into "QT", or "quantitative tightening", with an associated reduction in global capital flows - we continue to recommend only a neutral stance on global spread product, favoring U.S. corporates vs non-U.S. equivalents (especially avoiding EM credit). We also are maintaining our strategic recommended underweight stance on overall developed market duration, but favoring countries where monetary tightening will be more difficult to deliver (overweight U.K., Japan and Australia versus underweight U.S., euro area and Canada). A Quick Update On U.S. Treasuries: Stay Defensive Chart 3Stronger U.S. Growth = UST Underperformance The main U.S. data releases last week, the ISM surveys and the Payrolls report for August, came as a big surprise for the U.S. Treasury market. The headline ISM Manufacturing index hit a 17-year high of 61, led by increases in both the growth and inflation sub-components of the index (Chart 3), while the U.S. economy added another 200k jobs. The big shock came from the wage data in the Payrolls report, with Average Hourly Earnings rising by 0.4% in August, pushing the year-over-year growth rate to 2.9%, the highest since 2009. The Treasury market responded to data as expected, with the 10-year yield rising back to 2.94%. One of our favorite chart relationships shows the ISM Manufacturing index as a leading indicator of the momentum (12-month change) of core CPI inflation in the U.S. (Chart 4). The recent acceleration of U.S. core inflation can be explained as a lagged response to the U.S. economic growth acceleration since the start of 2016. If the relationship in this chart holds up, the current levels of the ISM are consistent with core CPI inflation accelerating to the 2.5-3% range next year. That outcome would keep the Fed on its planned rate hike path in 2019. At the moment, the market pricing of Fed rate expectations in the Overnight Index Swap (OIS) curve remains below the latest FOMC projections for the funds rate for the next two years (Chart 5). The 10-year TIPS breakeven inflation rate, which now sits at 2.1%, is still priced below the 2.3-2.5% levels that, in the past, have been consistent with inflation expectations staying well-anchored around the Fed's 2% inflation target. A combination of accelerating U.S. growth, faster wages, and a market that has not fully discounted the likely outcome for inflation and the funds rate is not a bullish one for U.S. Treasuries. We acknowledge that there could be a short-term flight-to-quality bid for Treasuries if the EM turbulence becomes more violent and finally spills over into the U.S. markets (likely through a rapid rise in the U.S. dollar). Yet without any signs of a meaningful slowing of U.S. growth or inflation, such a move would prove to be a short-lived trading opportunity rather than a true change in the rising trend for bond yields. Chart 4U.S. Inflation Acceleration Will Continue Chart 5Market Still Underpricing Fed Rate Hikes Bottom Line: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Turmoil, Then & Now, In Charts As discussed earlier, we see signs today of both of the most recent EM selloffs in 2013 and 2014/15 that were fueled by rising U.S. interest rates and a higher U.S. dollar. In the sets of charts beginning on Page 7 we present "cycle-on-cycle" analyses of several economic and financial indicators during those episodes, as well as this year. The charts are set up so that the blue lines represent the current EM selloff and the dotted lines in each panel represent how the same data series responded in 2013 (top panel of each chart) and 2014/15 (bottom panel of each chart). The vertical line represents the date of the trough in the U.S. dollar for each episode, which occurred in February 2018 for the current cycle. By looking at these charts, we can see how the current backdrop is evolving versus those prior episodes. The goal is to try to determine where things are similar, and different, to EM market declines in recent history. We are focusing on the areas where we believe there is the greatest concern over the potential spillovers from the current bout of EM stress - U.S. economic growth, Chinese economic growth and U.S. financial markets. We present the charts in a rapid "chartbook" format, with our overall conclusions at the end. Leading Economic Indicators: The OECD's leading economic indicator for the U.S. (Chart 6A) is currently off the high seen at the beginning of the year, following a path similar to 2014/15, but the latest data point has ticked higher. More importantly, the level is higher than at the same point in the 2013 and 2014/15 cycles. Meanwhile, the OECD (ex-U.S.) global leading economic indicator (Chart 6B) is following the depressed path of the 2014/15 episode, rather than the acceleration seen during the 2013 Taper Tantrum. Chart 6AU.S. Leading Indicator Following 2014/15 Path Chart 6BGlobal Leading Indicator Following 2014/15 Path U.S. Dollar: The rising dollar of 2018 (Chart 7A) looks more like the 2014/15 episode in terms of magnitude, although the greenback is at a lower level than during that earlier cycle (note that all lines are indexed to 100 at the date of the trough in the dollar at the vertical line). In 2013, the increase in the dollar was fairly mild, even with U.S. bond yields soaring higher, due to fact that non-U.S. growth was improving at the time. Chart 7AU.S. Dollar Following 2014/15 Path...So Far Chart 7BU.S. Investment Grade Returns Matching 2014/15 Path U.S. Corporate Bonds: The path of excess returns for U.S. investment grade corporate debt (Chart 7B) is tracking extremely tightly to the 2014/15 experience, with larger losses compared to this similar point during the Taper Tantrum. EM Equities & Credit: The widening in USD-denominated EM sovereign credit spreads in 2018 (Chart 8A) is in line with the 2014/15 cycle and has already surpassed the 2013 episode. The decline in EM equities (Chart 8B) has been worse than both prior EM selloffs. Chart 8AEM Equities Worse Than Both 2013 & 2014/15 Chart 8BEM Spreads Matching 2014/15 Path U.S. Interest Rates: Our 12-month fed funds discounter, which measures the amount of Fed rate hikes expected by the market over the next year, is higher than the 2014/15 episode and much higher than 2013 (Chart 9A). 10-year Treasury yields are at the same level as occurred at this point during the Taper Tantrum, and well above the levels seen in 2014/15 (Chart 9B). Chart 9AMore Fed Hikes Expected Than 2013 & 2014/15 Chart 9BUST Yields Following 2013 Path U.S. Labor Markets: Perhaps the biggest difference between the current backdrop and the prior EM selloffs is state of the U.S. labor market. The unemployment rate of 3.9% is much lower than the 5.6% rate seen during the 2014/15 cycle and the 7.6% level seen at this point during the Taper Tantrum (Chart 10A). That is translating to a faster pace of U.S. wage growth, measured by the annual percentage change in Average Hourly Earnings, than in either of the previous episodes of USD strength and EM turmoil (Chart 10B). Chart 10AMuch Lower U.S. Unemployment In 2018... Chart 10B...With Faster U.S. Wage Growth U.S. Inflation: Realized U.S. inflation, using core CPI, is higher now than in either of the previous episodes (Chart 11A). That can also been seen in the ISM Prices Paid index, which is far above the levels seen in both 2013 and 2014/15 (Chart 11B). Chart 11AHigher U.S. Inflation In 2018... Chart 11B...With Greater Inflation Pressures U.S. Economy: We can obviously show many charts here, but we think the most relevant are those related to signs that non-U.S. market turmoil and slowing growth is spilling back into the U.S. On that note, we show the ISM New Orders index in Chart 12A and the annual growth rate of total U.S. exports in Chart 12B. The New Orders index today is as strong as it was at this point during the Taper Tantrum, and much healthier compared to 2014/15 when New Orders were falling sharply. U.S. export growth is faster than both prior episodes, especially 2014/15 when exports contracted outright. Chart 12AStronger ISM New Orders In 2018... Chart 12B...With Healthier Export Demand China Economy: Again, we could use any number of data series in these charts, but we are keeping it simple and choosing indicators that show the impact of Chinese growth on the world economy. Chinese nominal GDP growth, currently at 9.8%, is the same as it was at this point in the 2013 cycle but much faster than during the 2014/15 period (Chart 13A). Importantly, however, China nominal GDP growth is decelerating now as it was in both of the prior episodes. Chinese annual import growth, up 19% in RMB terms, is faster now than in both prior periods of EM stress, especially compared to the contraction seen during the 2014/15 episode (Chart 13B). Chart 13AFaster, But Still Slowing, China GDP Growth Chart 13BStronger China Import Growth In 2018 U.S. Corporate Profits: Here is perhaps the biggest difference between today and the previous EM stress episodes. The annual growth in earnings-per-share for the S&P 500 rose to 18% in the 2nd quarter of this year, far above the zero growth rate seen at this point of the 2013 and 2014/15 cycles (Chart 14A). A big reason for the difference is the impact of the Trump corporate tax cuts this year, which has boosted operating margins well beyond levels seen in the prior two episodes (Chart 14B). Chart 14AFaster U.S. Profit Growth In 2018... Chart 14B...With Wider Margins Thanks To Tax Cuts EM Growth: An aggregate of EM Purchasing Managers Indices (PMIs) shows that the current bout of softer EM growth looks similar to the slowdowns in 2013 and 2014/15 (Chart 15A). In both prior cases, the PMIs eventually fell below 50, signifying economic contraction. In the 2013 episode, however, the PMI rebounded around the same point in the cycle as we are at today. Chart 15AEM Growth Slowing Similar To 2013 & 2014/15 Chart 15BU.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions: U.S. financial conditions are tighter now than the level seen at this point in the 2013 cycle and are as tight as witnessed at this point in the 2014/15 period (Chart 15B). After looking through all these charts, we can come up with the following conclusions: Chart 16Is It All Just "Q.T."? EM financial stress today is worse than 2013 and 2014/15 The U.S. economy is stronger today than in 2013 and 2014/15 U.S. external demand and corporate profits are both more robust today than in 2013 and 2014/15 U.S. inflation pressures are greater today than in 2013 and 2014/15 China's economy today, while slowing, is still growing faster than in 2013 and 2014/15 EM economic growth is slowing at the same pace as in 2013 and 2014/15. In terms of "benchmarking" where we are now compared to the previous two EM big EM selloffs, the fact that U.S. and Chinese economic growth is stronger today, and U.S. inflation is faster today, are the most important differences. This may even explain why U.S. markets are not reacting more negatively to the growing protectionist threats from the White house. Against this backdrop, it will require higher U.S. interest rates and a much stronger dollar before U.S. equities and credit markets finally suffer a serious pullback. In the end, though, the fact that U.S. and Chinese growth is better today does not suggest that a cautious investment stance is unwarranted. For the best correlation can be seen in our final chart (Chart 16), which shows the growth rate of the major developed market central bank balance sheets as a leading indicator of EM equity returns and developed market credit returns (and as a coincident indicator of government bond yields). If one were to only look at this chart, the weaker returns from global risk assets in 2018 can be fully explained by "quantitative tightening" and the resulting pullback in risk-seeking global capital flows compared the 2016/17. Bottom Line: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 204/15 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. Further, credit quality trends have been slowly moving against the sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 7, 2018) Chart 12Total Return Bond Map (As Of September 7, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Chart 1All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Chart 5Decomposing... Chart 6...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Chart 9...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades
Highlights 2018 YTD Summary: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Sector Portfolios: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Looking Ahead: We are maintaining a neutral level of target spread risk (i.e. duration-times-spread equal that of the benchmark index) in our sector model portfolios for the U.S., euro area and U.K. We will look to reduce that spread risk on signs of a deeper global growth slowdown, which we expect will unfold in 2019. Feature Chart of the WeekReversal Of Fortune The performance of investment grade (IG) corporate bonds in the developed markets, as an asset class, has been underwhelming so far in 2018. Using the total return indices from Bloomberg Barclays, IG corporates in the U.S., euro area and U.K. - the regions with the three largest corporate bond markets among the developed economies - have lost -2.0%, -0.3% and -1.1%, respectively. The numbers do not look much better when shown on an excess return basis versus duration-matched government bonds: U.S. IG -0.8%, euro area -1.2% and the U.K. -1.3%. The sluggish performance for IG corporates is a mirror image of the strong showing in 2017 when looking at credit spreads, which reached very tight levels at the end of last year (Chart of the Week). The 2017 rally left global corporates exposed to any negative shocks, of which there have been many so far in 2018 (the February VIX spike, the Q1 global growth slowdown, intensifying U.S.-China trade tensions, ongoing Fed tightening, a strengthening U.S. dollar, less dovish non-U.S. central banks, Italian politics, emerging market turmoil). Given the more challenging environment for overall corporate bond performance, the role of sector selection as a way to generate alpha, by mitigating losses from beta, is critical. In this Weekly Report, we take a brief look at IG sector performance so far this year and update our sector allocations based on our relative value models for IG corporates in the U.S., euro area and U.K. 2018 YTD Global Corporates Performance: A Down Year The major IG sector groupings for the U.S., euro area and U.K. are presented in Table 1, ranked by the 2018 year-to-date excess returns (all are shown in local currency terms). The overall index return for each region is also shown (highlighted in gray) in the table, to highlight how individual sectors have performed relative to the overall IG index. Table 12018 Year-To-Date Investment Grade Sector Returns For The U.S., Euro Area & U.K. As is always the case with IG corporates, the performance of the broad Financials grouping (which includes banks, insurance companies, REITs, etc.) heavily influences the returns of the overall IG index given the large weighting of Financials within the Corporates index across all three regions. In both the euro area and U.K., the sharp underperformance of Financials seen year-to-date (-1.3% and -1.4%, respectively) has created a somewhat odd situation where the majority of sectors have outperformed the overall index. That could only happen given the large weight of Financials in the euro area index (40%) and U.K. index (43%). Financials are also a big part of the U.S. index (32%), but there is more balance in the U.S. IG index which has helped boost the "beta" return from U.S. corporates. Specifically, the weightings of the top three largest U.S. broad sector groupings - Energy (9%), Technology (8%) and Communications (9%) - are a combined 26% of the overall U.S. IG index. Those three sectors are also among upper tier of the 2018 performance table in the euro area and U.K., but only represent a combined 15% and 8%, respectively, of each region's IG index. The conclusion is that index composition has flattered the performance of U.S. IG corporates versus European equivalents, given the latter's heavier weighting in Financials. The poor performance of Financials can be attributed to flattening global government bond yield curves (which is a negative for banks) and poor returns from global credit, especially in emerging markets (which is a negative for insurers that invest in spread product). We do not anticipate either of those trends reversing anytime soon - particularly the ongoing selloff in emerging market assets - thus Financials are likely to remain a drag on corporate bond performance for at least the next 3-6 months. One other factor that has weighed on overall IG corporate performance has been the steepening of credit spread curves. The gaps between credit spreads for Baa- and A-rated corporates have widened since the end of January, most notably in the euro area and the U.K. where growth has been slower than in the fiscal-policy fueled U.S. economy (Chart 2). With Baa-rated debt now representing one-half of the IG index for the U.S., euro area and U.K. (Chart 3) - a function of rising corporate leverage - continued underperformance of lower quality sectors will negatively impact the future overall returns from IG corporates. Chart 2Spread Curves Are##BR##Steepening In Europe Chart 31/2 Of Investment Grade Corporate Indices##BR##Are Now Baa-Rated Looking ahead, credit investors should be wary of the potential for downgrade risk in their portfolios given the high proportion of Baa-rated debt in the IG benchmark indices. This risk will become more acute when the global business cycle runs out of steam (a 2019 story, at the earliest, in our view). Bottom Line: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Corporate Sector Valuation Models: Winners & Losers Our recommended IG sector allocations come from our relative value model, which measures the valuation of each individual sector compared to the overall Bloomberg Barclays corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all other sectors in each region. The dependent variables in the model are each sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that panel regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 13. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. We then apply individual sector weights based on the model output and our desired level of overall spread risk in our recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. That target portfolio DTS is the first decision in our discretionary allocation process, which is informed by our strategic views on corporate credit in each region. For example, if we were recommending an overweight allocation to U.S. IG corporates, then we would target a portfolio DTS that was greater than the index DTS. If we then became a bit more cautious on U.S. corporates, we could reduce the target DTS (spread risk) of our model sector portfolio while maintaining an overall overweight allocation to U.S. corporates versus U.S. Treasuries. That is exactly what we did one year ago, when we began to target a weighted DTS of all our individual sector tilts that was roughly equal to the overall IG corporate index DTS for each region (U.S. euro area, U.K.) while maintaining an overall overweight stance on global corporate credit versus government debt. More recently, we have downgraded our stance on global spread product to neutral, while continuing to favor the U.S. over Europe, in response to growing tensions from emerging markets and the brewing U.S.-China trade war.1 Chart 4Performance Of Our IG Sector Allocations We last presented a performance update for our global IG corporate sector allocations back on April 12th of this year. Since then, our recommended tilts have modestly underperformed the benchmark index in excess return terms by a combined -3bps (Chart 4). This came entirely from the euro area, with both the U.S. and U.K. sector allocations simply matching the benchmark index. Year-to-date, our IG sector allocations have underperformed the benchmark by a combined -9bps in excess return terms, split equally among the U.S., euro area and U.K. This is a result entirely consistent with our long-standing stance to overweight Financials in all three regions, which continue to appear cheap in our valuation framework. Also, an increasing number of sectors had become expensive within that framework, in all three regions, so some portion of that overweight to global Financials was "by default" given that our model portfolios must be fully invested (finding value has been a persistent problem for credit investors over the past year). The return numbers for our U.S. sector allocations can be found in Table 2. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have all been underweights: Pharmaceuticals (+1.2bps), Electric Utilities (+1.1bps), Retailers (+0.6bps), Health Care (+0.6bps), Diversified Manufacturing (+0.5bps) and Chemicals (+0.4bps). These were fully offset, however, by underperformance from our large overweights to Energy (-4.1bps) and Financials (-2.7bps). Table 2U.S. Investment Grade Performance The return numbers for our euro area sector allocations - shown here hedged into U.S. dollars as is the case when we present all our model portfolio returns - can be found in Table 3. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been underweights to Transportation (+2.0bps) and Electric Utilities (+0.6bps), with underperformance coming from our underweight to Food/Beverage (-2.4bps) and overweight to Life Insurers (-3.1bps). Table 3Euro Area Investment Grade Performance The return numbers for our U.K. sector allocations (again, hedged into U.S. dollars) can be found in Table 4. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been our underweight to Utilities (+2.0bps) and Consumer Non-Cyclicals (+0.9bps), but this was nearly fully offset by our large overweight to Financials (-2.6bps). Table 4U.K. Investment Grade Performance Despite the underperformance of our sector portfolios year-to-date, the cumulative alpha from the portfolios since we began tracking the performance of the recommendations remains positive (+2bps in the U.S., +9bps in the euro area, +42bps in the U.K.). Bottom Line: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Changes To Our Sector Model Portfolios As mentioned earlier, the first choice we make when determining the recommended sector allocations within our model portfolios is how much spread risk (DTS) to take. For the U.S., euro area and U.K., we have already been maintaining a portfolio DTS that is close to the index DTS since August 2017. After our recent decision to downgrade global spread product allocations to neutral versus government bonds, we do not feel a need to further reduce our spread risk by targeting a below-index DTS. That would likely be our next decision when we wish to get more defensive on credit, which would await evidence that global leading economic indicators are sharply slowing and/or global monetary policy is becoming restrictive. Within that neutral level of spread risk, we are making the following portfolio changes based on the updated output from our valuation models presented in the Appendix Tables on pages 13-18. The goal is to favor sectors that have a DTS close the index DTS but have positive valuation residuals from our model: U.S.: We downgrade Tobacco and Wireless to Neutral; we downgrade Paper to Underweight. Euro Area: We upgrade Transportation, Other Industrials, Natural Gas, Brokerages/Asset Managers and Finance Companies to Overweight; we upgrade Automotive, Retailers and Tobacco to Neutral; we downgrade Wireless to Neutral; we downgrade Diversified Manufacturing & Media Entertainment to Underweight. U.K.: We upgrade Health Care, Transportation and Other Industrials to Overweight; we upgrade Integrated Energy to Neutral; we downgrade Technology & Wireless to Neutral; we downgrade Metals & Mining and Supermarkets to underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 31, 2018. The quant model has further lifted its U.S. allocation to overweight from neutral, and the U.K. underweight has also been reduced by half. On the other hand, Italy is downgraded and the overweight in Spain, Germany and the Netherlands are all significantly reduced, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 32 bps in August, largely driven by Level 2 model which underperformed its benchmark by 75 bps. expected, the model did not catch the "Turkey Effect" which drove deep losses in the Italian and Spanish markets. The Level 1 model slightly unperformed its MSCI World benchmark by 2 bps in August. Since going live, the overall model has outperformed its benchmarks by 87bps, driven by the Level 2 outperformance of 260 bps offset by the 5 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, The GAA Equity Sector Selection Model has been live since July 2016, and has outperformed the benchmark over this period in line with our back-testing. However, GICS will make significant changes to sector compositions at the end of September, most notably creating a new "Communication Services" sector, dominated by internet-related companies, to replace "Telecommunication Services". However, MSCI has not yet made available the final details of membership or historical performance of the revised sectors. Accordingly, after this update we are temporarily suspending publication of this model until full data is available and we have been able to rebuild the model using the newly constituted sectors. The GAA Equity Sector Selection Mode (Chart 4) is updated as of August 31, 2018. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The model continues to have a negative outlook on global growth and consequently has a net underweight on cyclical sectors. However, the magnitude of this tilt was reduced from 5.8% to 2.8%. The biggest move was a downgrade of consumer staples from a 2.5% overweight to a 1.4% underweight on the back of unfavorable momentum indicators. The only two sectors with favorable momentum are healthcare and technology. Finally, energy stocks also saw a 0.8% boost in its overweight recommendation on the back of attractive valuations. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com
Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Chart 1U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Chart 13Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation